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Indexation as Primary Target for Pension Funds: Implication for Portfolio Management

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The current financial crisis has strongly affected the financial status (expressed by the funding ratio) of the pension funds and their ability to grant full indexation of the liabilities to inflation rate. The indexation benefits represent a priority for a participant of a pension fund bearing purchasing power risk. Differently from return-oriented optimisation, we define an objective function based on the indexation decision, which is conditional on the financial status of the fund. The paper focuses on the definition of an ALM model aimed to maximise the indexation grant by the defined benefit pension fund to its participants by introducing real assets in the portfolio, but also imposing risk-based regulation. The model is applied to the portfolio of the ABN AMRO pension fund, which aims to fully index its liabilities with respect to the Dutch inflation. The results suggest the initial funding ratio strongly affects the ability of the fund to set a fully-indexed investment strategy over longer horizon, while changes in the risk aversion parameter have a limited influence. A crucial role is played by Property which are also preferred to Equity, while Commodity have risk diversification properties exploitable only in the long run for higher funding ratio, otherwise the regulatory framework takes the form of a barrier to invest in commodities.

Suggested Citation

  • Gallo, Angela, 2011. "Indexation as Primary Target for Pension Funds: Implication for Portfolio Management," Journal of Financial Transformation, Capco Institute, vol. 31, pages 173-183.
  • Handle: RePEc:ris:jofitr:1449
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    Keywords

    Pension fund; asset allocation; inflation;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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