A liability-relative drawdown approach to pension asset liability management

Abstract

© Palgrave Macmillan, a division of Macmillan Publishers Limited 2011. Defined benefit pension schemes accumulate assets with the ultimate objective of honouring their obligation to the beneficiaries. Liabilities should be at the centre of designing investment policies and serve as the ultimate reference point for evaluating and allocating risks and measuring performance. The goal of the investment policy should be to maximize expected excess returns over liabilities subject to an acceptable level of risk that is expressed relative to liabilities. In this chapter, we argue for the use of a liability-relative drawdown optimization approach to construct investment portfolios. Asset and liability returns are simulated using a vector autoregressive process with state variables. We find that drawdown optimal portfolios provide better downside protection, are better diversified and tend to be less equity centric while providing higher expected returns than surplus variance portfolios.