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Optimal Long-Term Allocation with Pension Fund Liabilities

Author

Listed:
  • Eric JONDEAU

    (University of Lausanne and Swiss Finance Institute)

  • Michael ROCKINGER

    (University of Lausanne and Swiss Finance Institute)

Abstract

We build a macroeconomic model for Switzerland, the Euro Area, and the USA that drives the dynamics of several asset classes and the liabilities of a representative Swiss (defined-contribution) pension fund. This encompassing approach allows us to generate correlations between returns on assets and liabilities. We calibrate the economy using quarterly data between 1985:Q1 and 2013:Q2. Using a certainty equivalent approach, we demonstrate that a liabilities hedging portfolio outperforms an assets-only strategy by between 5% and 15% per year. The main reason for such a large improvement is that the optimal assets-only portfolio is typically long in cash, whereas hedging liabilities require the pension fund to be short in cash. It follows that imposing positivity restrictions in the construction of the portfolio also results in a large cost, between 4% and 8% per year. This estimate suggests that allowing pension funds to hedge their liabilities through borrowing cash and investing in a diversified bond portfolio helps to enhance the global portfolio return.

Suggested Citation

  • Eric JONDEAU & Michael ROCKINGER, 2014. "Optimal Long-Term Allocation with Pension Fund Liabilities," Swiss Finance Institute Research Paper Series 14-58, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1458
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    More about this item

    Keywords

    Asset Liability Management; Defined Contributions; Surplus maximization;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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