The Optimal Portfolio Allocation for Corporate Pension Funds

Abstract

We model the asset allocation decision of a stylized corporate defined benefit pension fund. Besides including 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), the key feature of our model is that asset allocation decisions are made by fiduciaries who 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 and a sponsoring employer who may make good any shortfall in assets, and who may reclaim some pension surplus. We find that even simple asymmetries in payoffs have large effects on asset allocation which are highly persistent over time in a dynamic framework. In contrast with models of pension asset allocation that ignore these factors, we are able to substantially replicate observed DB pension asset allocations in the UK and US. We conclude that institutional details - in particular asymmetries in payoffs to pension fiduciaries - are crucial in understanding DB pension asset allocation.

Keywords: agency cost, corporate pensions, asset allocation

JEL Classification: G20, G23, J32