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Cost and risk-reduction benefit of hedging inflation risk for Dutch defined-benefit pension funds

Zorba, Walid (2020) Cost and risk-reduction benefit of hedging inflation risk for Dutch defined-benefit pension funds.

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Abstract:Inflation has recently garnered the attention of Liability-Driven Investment (LDI) strategists because of its unusually low level. Though it might seem desirable on the surface, it alarms asset management firms as they expect a sharp increase in the upcoming years due to its supposed ergodic nature. As such, the promised benefits could wane unless Dutch pension funds hedge inflation risk from their balance sheet. The problem is, if inflation still stays low, the hedge will damage their assets. The overarching goal of this technical report is to determine whether it is worthwhile hedging inflation risk from a Dutch pension fund’s balance sheet or not. NN Investment Partners manages the portfolios of Dutch pension funds. Its role is to ensure their clients remain sufficiently well-funded to pay their soft obligations in full by providing them with sound recommendations based on future market expectations. To capture a wide-range of possible scenarios, we build an Economic Scenario Generator (ESG) in MATLAB that produces future asset returns, in a Time-Frequency Representation. Concretely, we simulate inflation-sensitive balance sheet items as stochastic variables by modelling inflation swap rates and interest swap rates as a composed Ornstein–Uhlenbeck process, and global equity as a composed random walk with an upward drift. Afterwards, we import our figures to the company’s balance sheet simulation tool and observe what happens to the coverage ratio distribution at the end of our time horizon every time we gradually increase the inflation hedge ratio; the results are remarkable. The more we hedge, the higher the expected nominal and real coverage ratio; conversely, the less we hedge, the lower the expected nominal and real coverage ratio. Moreover, the risk profile of the pension fund improves substantially as the volatility of its real coverage ratio distribution decreases when we increase the hedge ratio. Therefore, if our simulation is correct, we advise Dutch pension funds to hedge their inflation exposure entirely to jointly a) maximize their funding position and b) minimize their balance sheet risk. However, we do recognize our models are based on a set of assumptions. For instance, they violate the risk-neutral framework; both models rely on true probabilities instead (i.e., historical probabilities). We identify other possible limitations and discuss their practical implications on the Dutch pension landscape towards the end of the paper.
Item Type:Essay (Master)
Faculty:BMS: Behavioural, Management and Social Sciences
Subject:31 mathematics, 50 technical science in general, 83 economics, 85 business administration, organizational science
Programme:Industrial Engineering and Management MSc (60029)
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