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Optimal Investment Policies for Defined Benefit Pension Funds

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  • A.H. Siegmann

Abstract

This paper analyzes optimal investment policies for pension funds of a defined benefit (DB) type. The nature of a DB fund induces a natural modeling of preferences being of the mean-downside risk type. With compensation for inflation as an explicit goal of a pension fund, a natural reference point for the risk measure is the real or indexed value of the liabilities. Results are presented for a mean-shortfall model and different assumptions for inflation uncertainty, correlation between inflation and stock returns, and the level of the risk-free rate. Comparative statics show increased risk-taking for funding ratios moving away from the reference point. We provide intuition for the results and compare the outcomes with actual investment policies of six large Dutch pension funds.

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File URL: http://www.dnb.nl/binaries/wo0728_tcm46-146019.pdf
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Bibliographic Info

Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 728.

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Date of creation: 2003
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Handle: RePEc:dnb:wormem:728

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Keywords: pension funds; optimal investment; defined benefit;

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  1. Maranas, C. D. & Androulakis, I. P. & Floudas, C. A. & Berger, A. J. & Mulvey, J. M., 1997. "Solving long-term financial planning problems via global optimization," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1405-1425, June.
  2. Shlomo Benartzi & Richard H. Thaler, 1993. "Myopic Loss Aversion and the Equity Premium Puzzle," NBER Working Papers 4369, National Bureau of Economic Research, Inc.
  3. Randall S. Hiller & Jonathan Eckstein, 1993. "Stochastic Dedication: Designing Fixed Income Portfolios Using Massively Parallel Benders Decomposition," Management Science, INFORMS, vol. 39(11), pages 1422-1438, November.
  4. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272.
  5. Hirshleifer, David, 2001. "Investor Psychology and Asset Pricing," MPRA Paper 5300, University Library of Munich, Germany.
  6. Zenios, Stavros A. & Holmer, Martin R. & McKendall, Raymond & Vassiadou-Zeniou, Christiana, 1998. "Dynamic models for fixed-income portfolio management under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 22(10), pages 1517-1541, August.
  7. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
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Cited by:
  1. Liu, Shuangzhe & Ma, Tiefeng & Polasek, Wolfgang, 2012. "Spatial System Estimators for Panel Models: A Sensitivity and Simulation Study," Economics Series 294, Institute for Advanced Studies.
  2. Arjen Siegmann, 2008. "Minimum Funding Ratios for Defined-Benefit Pension Funds," DNB Working Papers 180, Netherlands Central Bank, Research Department.
  3. Peter Vlaar, 2005. "Defined Benefit Pension Plans and Regulation," DNB Working Papers 063, Netherlands Central Bank, Research Department.
  4. Fortin, Ines & Hlouskova, Jaroslava, 2012. "Optimal Asset Allocation under Quadratic Loss Aversion," Economics Series 291, Institute for Advanced Studies.

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