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The Pension Protection Fund
Abstract
We develop a stylised model of the UK Pension Protection Fund (PPF), a defined
benefit pension guarantee system for the UK, based on an analogy between pension
liabilities and corporate debt obligations. We show that the PPF is likely to face many
years of low claims interspersed irregularly with periods of very large claims. There
is a significant chance that these claims will be so large that the PPF will default on its
liabilities, leaving the Government with no option but to bail it out. The cause of this
problem is the mismatch between pension assets (largely invested in equities in the
UK) and liabilities (which are bond-like). This will cause many firms to default when
their pension plans are heavily underfunded. We use our model to derive a fair
premium for PPF insurance under different circumstances, to estimate the extent of
cross-subsidies in the PPF between strong and weak sponsors and to show that risk
rated premiums are unlikely to have a substantial effect on either the size or the
lumpiness of claims. We argue that for the PPF to operate effectively, it should be
introduced in tandem with strong minimum funding requirements and a lower level of
benefit guarantee than at present.
David McCarthy
Lecturer, Finance Group
Tanaka Business School at Imperial College
South Kensington, SW7 2AZ
E-mail: dg.mccarthy @imperial.ac.uk
Phone: 0207-594-9130
Anthony Neuberger
Associate Professor, London Business School
Regents Park, NW 1 4SA
E-mail: aneuberger @
Phone: 0207-262-5050
The Pension Protection Fund
The UK has recently established a Pension Protection Fund (PPF) to protect members
1
of private sector defined benefit scheme whose firms become insolvent (Department
of Work and Pensions, 2004a). Many details of the
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