Valuation of the Conditional Indexation Option in Asset and Liability Management of Defined Benefit Pension Funds

Pension funds have adopted different management approaches to overcome the arising difficulties to maintain a solid financial status. Among these, there is the adoption of an indexation policy which is conditional on the solvability of the fund. Pension funds recognizing conditional inflation indexation are obliged to pay an additional payoff 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; in most cases, the measure is linked to an asset/liability ratio able to capture the solvability of the fund. Therefore, a full valuation of the obligation towards funds participants cannot exclude the proper appraisal of this additional option. The option payoff is conditional to a measurement asset that is different from the reference underlying asset. This structure recalls a barrier option with different measurement and payoff asset. The paper investigates the opportunity to apply barrier option schemes in an asset/liability context to provide a full valuation of the obligation towards participants. Results derive from a simulation procedure applied by means of scenario-based analysis. Numerical results give the opportunity to state the absolute and relative value of the inflation option