Incorporating Uncertainty About Alternative Assets in Strategic Pension Fund Asset Allocation

Abstract

We present an asset allocation framework for pension funds in which they can take pension liability risk and uncertainty about future expected asset returns explicitly into account. This framework recognized the liability hedging properties of assets that correlate positively with changes in the market value of pension liabilities. In addition, uncertainty about the expected returns, especially on alternative asset classes can be taken into account to arrive at realistic and acceptable asset allocations compared with standard portfolio optimization models. The empirical examples for pension funds in the United Kingdom indicate that for modest assumptions on expected returns of alternative assets ranging between 2 and 3 per cent above pension liabilities, the optimal portfolio allocation to alternatives ranges between 15 and 30 per cent.