Pension Plan Valuation

This paper provides a new formal framework to value final-salary defined-benefit pension plans. The valuation framework proposed builds on the familiar idea of discounting future cash flows. Hence, the first step of the valuation process is to find a closed-form solution of the pension fund's future cash flows. Second, by applying the appropriate yield curve to discount the fund's future cash flows, the net-present value (NPV) formula emerges. This valuation framework is first applied in a deterministic environment. More precisely, the demographic and financial variables driving the fund's future cash flows - namely the dynamics of the fund's population and salary distribution - are not subject to uncertainty. Then, the two-step valuation framework is generalized to incorporate risk. Con- cretely, the three risk factors mortality, morbidity and salary inflation, which are described by a joint VAR(1)-process, aect the pension plan's future cash flows.