The Fair Value of Pension Liabilities: the case of Embedded Option in Scenario Analysis

Pension funds evolved over time towards the adoption of more complex risk-sharing schemes in order to keep up with the financial market complexities and volatility. Among these, the adoption of an indexation policy is widespread and it is now conditional to the solvability of the fund. Pension funds recognizing conditional inflation indexation targets are obliged to pay an additional payoff that is linked to the inflation rate through some specific rule. The additional payoff normally takes the form of a contingent claim conditional to a “measure” of sustainability of the payoff itself. This contingent claim can be valued with the same techniques that are used to value options. This valuation technique is an indispensable tool for improving pension fund risk management and correlated fair valuation issues. The paper provides a valuation methodology for the inflation indexation as embedded option by means of scenario-based analysis. Results derive from a simulation procedure applied to an exemplar case and give the opportunity to state the nature and the value of the indexation option.