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Kocken, T.P. (2006)Curious Contracts: Pension Fund Redesign for the Future

Summary (partial)

"Some thirty years ago, Peter Drucker alerted Western society to an inevitable revolution. He unravelled the postwar baby boom, showing it to be a transitory phenomenon in a trend of decreasing fertility rates that started much earlier, together with ever increasing longevity numbers. He was convinced that around the turn of the century, this would cause an upheaval in our society that would put the entire social welfare system at risk and would require redesign. Pension funds would happen to be at the forefront of this revolution.244 He was right, although he did not foresee in the mid-seventies how little proactive behaviour would take place over the next few decades.245 In this context, it is ironic that those countries that are already best prepared in terms of pension capital accumulated (among others the US, the UK, the Netherlands and the Scandinavian countries) are the most active in adapting the pension fund situation to the new era. Apparently, there is a more acute perception of risk where a large capital basis already exists than with a much more worrisome pay-as-you-go system that does not reveal future problems.

Around the time Drucker revealed his remarkable foresight, Fischer Black, Myron Scholes and Robert Merton revealed their sublime technical skills by inventing the arbitrage free option pricing theory. This innovation changed the structure of financial markets and the profession of risk management considerably.

The striking issue with respect to these two events is that the Defined Benefit pension fund concept happens to be based completely on options, wrapped up in a kind of collective system. But pension policymakers hardly ever rely on (embedded) option theory to gain insight in their system and therefore it is not used as a basis for new design in order to properly anticipate the rapidly aging population. The current pension fund system is based on a wealth and risk redistributing system that may entail too much pressure on future participants to be sustainable. The exact nature and magnitude of this pressure and possible solutions in redesign and hedging are investigated in this thesis by applying option theory and risk management concepts."

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