Abstract
In conventional portfolio management returns are maximised subject to given risk levels. In this framework the only variables of relevance are risk and returns and their interrelationship as expressed in terms of the efficient frontier. It is increasingly the view of investment managers and regulators that pension fund investment strategies need to take their liabilities into consideration when constructing investment portfolios. In this paper we compare the conventional portfolio management approach to asset allocation which aligns investment strategies to a defined liability index. We consider a numerical example based on the Icelandic public sector pension obligation index. A comparison between the conventional risk-return focused approach and the one that seeks to align investment strategies to liabilities shows that the latter approach provides superior performance on market data covering the historical time period from Jan. 2003 to Jan. 2012. The study shows that the liability driven approach performed better in the market downturn in the second half of 2008. Also, a portfolio constructed around liabilities recovered quicker in the years following the market crash.
Highlights
Pension funds play a hugely important role in today’s modern societies
The data considered consists of the pension obligation index (POI) for employees in the Icelandic public sector (Numerical Data, Statistics Iceland, 2013), as an index for liabilities, and of eight asset class indices assumed to be representative for the investments available to a hypothetical Icelandic pension funds at the time of the analysis, Table 1
In recent years the performance of pension funds has come under much scrutiny
Summary
Pension funds play a hugely important role in today’s modern societies. They manage people’s life savings, the money they have accrued over their working life, and plan to spend in their retirement years. Two equity market shocks have occurred since the high-tech bubble burst in late 2000 and a number of economies have still not recovered fully from the 2008 crisis During this time many pension funds have not managed to cover their liabilities. The asset allocation of pension funds needs to be guided by its aim to provide returns that dominate the returns of the liability index, at an acceptable risk level. Viewed this way the core role of asset allocation modelling is to better manage uncertainty and to provide a tool for making important investment decisions. In the final section we summarise and discuss the results and make some suggestions for future research
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