by Zvi Bodie
Boston University
Failure to take account of the mismatch between the assets in defined-benefit pension plans (primarily equities) and the liabilities (deferred fixed annuities) has long been a major unrecognized source of financial instability. The underfunding problems now facing state and local government pension plans and the Pension Benefit Guaranty Corporation are a direct consequence of this conceptual and practical failure. Yet the source of the problems and the policies needed to correct these problems remain unrecognized by many, if not most, mainstream economists. This essay uses option-pricing theory to show how to efficiently manage the pension mismatch risk and the consequences of failure to do so.
JEL Codes: E, G, H.
Full article (PDF, 11 pages 272 kb)
Discussion by Arturo Estrella