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Optimal Portfolio Allocation for Corporate Pension Funds

  • McCarthy, David
  • Miles, David K

We model the asset allocation decision of a defined benefit pension fund using a stochastic dynamic programming approach. Our model recognizes the fact that asset allocation decisions are made by trustees who are mandated to act in the best interests of beneficiaries - not by sponsoring employers - and that trustees face payoffs that are linked in an indirect way to the value of the underlying assets. This is because of the presence of pension insurance - which may cover a portion of deficits in the event of a sponsor default - and a sponsoring employer who may make good any shortfall in assets, and who may reclaim some pension surplus. Our model includes an allowance for uncertainty both of the future value of assets (because of uncertain investment returns) and liabilities (because of uncertainty in future longevity and in future interest rates). We find that we are able to substantially replicate observed DB pension asset allocations in the UK and conclude that institutional details - in particular asymmetries in payoffs to pension trustees - are crucial in understanding pension asset allocation.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6394.

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Date of creation: Jul 2007
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Handle: RePEc:cpr:ceprdp:6394
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  1. Andreas Graflund & Birger Nilsson, 2003. "Dynamic Portfolio Selection: the Relevance of Switching Regimes and Investment Horizon," European Financial Management, European Financial Management Association, vol. 9(2), pages 179-200.
  2. Marcus, Alan J, 1985. " Spinoff-Terminations and the Value of Pension Insurance," Journal of Finance, American Finance Association, vol. 40(3), pages 911-24, July.
  3. Roel M. W. J. Beetsma & A. Lans Bovenberg, 2009. "Pensions and Intergenerational Risk-sharing in General Equilibrium," Economica, London School of Economics and Political Science, vol. 76(302), pages 364-386, 04.
  4. Sharpe, William F., 1976. "Corporate pension funding policy," Journal of Financial Economics, Elsevier, vol. 3(3), pages 183-193, June.
  5. Treynor, Jack L, 1977. "The Principles of Corporate Pension Finance," Journal of Finance, American Finance Association, vol. 32(2), pages 627-38, May.
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