DC pension fund benchmarking with fixed-mix portfolio optimization

Abstract

Corporate sponsored defined benefit (DB) pension schemes have recently found themselves in hot water. Accounting practices that led to over-exposure to equity markets, increases in longevity of the scheme participants and low interest rates have all contributed to the majority of schemes in the EU and the UK finding themselves underfunded. In essence, a DB scheme promises to pay its participants an annuity at retirement that gives them a pension equal to a proportion of their final salary (the proportion depending on the number of years of service). Therefore the responsibility to meet these promises (liabilities) rests firmly with the scheme’s trustees and ultimately with the corporate sponsor. The management of these corporate schemes was greatly affected in the past by quarterly earnings reports which directly impacted stock prices in the quest for ‘shareholder value’. Consequently DB scheme sponsors resorted to a management style that was able to keep the liabilities, if not off the balance sheet, then at least to a minimum. One sanctioned tactic that achieved these aims was the ability to discount liabilities by the expected return of the constituent asset classes of the fund. In other words, by holding a large part of the fund in equities, the liabilities could be discounted away at over 10% p.a. The recent performance of the equity markets and the perception of equity as a long-horizon asset class assisted in justifying this asset-mix in the eyes of the scheme’s trustees. However, with the collapse of the equity-market bubble in 2001, many funds found their schemes grossly underfunded and were forced to crystallize their losses by panicked trustees. Consequent tightening of the regulations has made the situation even worse (e.g. all discounting must be done by the much lower AA credit quality bond yield rates in the UK FRS17 standard). As a result many DB schemes have closed and are now being replaced with defined contribution (DC) schemes.y In this world of corporate sponsored DC pension schemes the liability is separated from the sponsor and the market risk is placed on the shoulders of the participants. The scheme is likely to be overseen by an investment consultant and if the scheme invests in funds that perform badly over time a decision may be made by the consultant to move the capital to another fund. However, any losses to the fund will be borne by the participants in the scheme and not by the corporate sponsor. Since at retirement date scheme participants will wish to either purchase an annuity or invest their fund payout in a self-managed portfolio, an obvious need arises in the market place for real return guaranteed schemes which