When Do Derivatives Add Value in Pension Fund Asset Allocation?

Abstract

Recent surveys indicate that many pension-fund participants aim for higher retirement income security. We investigate the added value of including derivatives in the portfolio of pension funds to achieve this goal. To do so, we define preferences that incorporate specific features of pension funds, but we also report performance among several key criteria used in practice. Furthermore, we model explicitly that the equity market exhibits both jump risk and volatility risk. Our results show that even relatively small investments in derivatives can achieve improvements in certainty equivalent rates of return and other important performance measures. This confirms the intuition that the use of derivatives allows pension investors to make explicit risk and return tradeoffs and diversify between diffusion risk, jump risk, and volatility risk.

Keywords: Derivatives, Optimal Portfolio Choice, Pension Fund, Stochastic Volatility and Jump Risks