The Financial Theory of Defined Benefit Pension Schemes

ABSTRACT Increasingly, modern business and investment management techniques are founded on approaches to measurement of profit and risk developed by financial economists. This paper begins by analysing corporate pension provision from the perspective of such financial theory. The results of this analysis are then reconciled with the sometimes contradictory messages from traditional actuarial valuation approaches and the alternative market-based valuation paradigm is introduced. The paper then proposes a successful blueprint for this mark-to-market valuation discipline and considers whether and how it can be applied to pension schemes both in theory and in practice. It is asserted that adoption of this market based approach appears now to be essential in many of the most critical areas of actuarial advice in the field of defined benefit corporate pension provision and that the principles can in addition be used to establish more efficient and transparent methodologies in areas which have traditionally relied on subjective or arbitrary methods. We extend the hope that the insights gained from financial theory can be used to level the playing field between defined benefit and defined contribution arrangements from both corporate and member perspectives.