227 - An institutional evaluation of pension funds and life insurance companies

DNB Working Papers
Date 4 December 2009

This paper compares two different types of annuity providers, i.e. defined benefit pension funds and life insurance companies. One of the key differences is that the residual risk in pension funds is collectively borne by the beneficiaries and the sponsor while in the case of life insurers, it is borne by the external shareholders. This paper employs a contingent claim approach to evaluate the risk return trade-off for annuitants. For that, we take into account the differences in contract specifications and in regulatory regimes. Mean-variance analysis is conducted to determine annuity choices of consumers with different preferences. Using realistic parameters we find that under linear and quadratic utility, life insurance companies always dominate pension funds, while under other utility specifications this is only true for low default probabilities. Furthermore, we find that power utility consumers are indifferent if the long term default probability of pension funds exceeds that of life insurers by 2 to 4%.

Keywords : Pension plans, barrier options, contingent claim approach, mean-variance analysis.

JEL Classification : G11, G23.