Liability-Driven Allocation for Pension Portfolios
Summary
The document discusses how to allocate assets for an institutional portfolio whose purpose is to meet pension liabilities. It distinguishes liability-driven investing from benchmark-driven investing and recommends first establishing the client’s objectives, time horizon, liquidity needs, tax considerations, legal constraints, and other requirements. Asset-liability management can set a return target based on the obligations, dedicate assets to meeting those needs, and manage any surplus separately. The discussion also cautions that correlations between investments and the client’s business may matter.
One proposed implementation separates a risky, dynamically rebalanced multi-asset portfolio from a safe portfolio of duration-matched bonds and cash. Constrained mean-variance optimization guides the risky allocation, while a gradual shift into safe assets resembles a CPPI approach. Options on relevant benchmarks are suggested to reduce basis risk. The material is a brief discussion rather than a detailed allocation model: it gives no optimization inputs, performance evidence, or rules for choosing the portfolio split, and stresses that a client-specific investment policy is needed.
Key ideas
- Pension portfolios should begin with the liabilities and the client’s investment policy objectives.
- Asset-liability management can dedicate assets to meeting obligations before managing any surplus for performance.
- A proposed structure separates a duration-matched safe portfolio from a dynamically allocated multi-asset risky portfolio.
- Gradually shifting assets into the safe portfolio resembles a CPPI approach to protecting liabilities.
- Client constraints and correlations with the client’s business can affect suitable allocations.
Tags
Full text
# Multi-asset class allocation
# Multi-asset class allocation
How to allocate asset classes in a multi-asset portfolio?
An institutional client needs to meet his pension liabilities, and suggested a multi-asset-class strategy. I'm trying to find ideas to pitch.
My experience is mostly from equity, so the way to go would be to balance some kind of covariance based risk minimization with a 1/n-style diversification, both to avoid concentration risks, as well as dependency on the model. Then possibly buy some puts to reduce downside risks, etc.
I'm really not sure however how/how much to allocate to other classes. Would you use a covariance based approach, and optimize over those? Would you pick a class allocation and stick with it? Follow marco-trends? I guess you can do any of those, but is there a 'standard' approach? Can you even use covariances to diversify bonds against stocks against commodities?
Right now my idea is to start 95% equity/5% cash, and then shift to duration matched bonds to meet the liabilities. That way, I can handle the equity with the options, potentially have some base risks, and take care of the liabilities in advance.
## Answer by vonjd (score 4)
https://quant.stackexchange.com/a/18406
In this case it is important to differentiate between a liability-driven investment strategy (LDI) and a (the classical) benchmark-driven investment strategy. The first one is what you need in this case.
LDI was first established by Martin Leibowitz in 1986 ("Liability returns: A new perspective on asset allocation"). So googling that might help you already.
To dive into the matter and for many more details on all of your questions above (which are quite broad!) I would recommend the following current book:
Ang, A.: "Asset Management. A systematic approach to factor investing", Oxford University Press, 2014.
## Answer by vega (score 3)
https://quant.stackexchange.com/a/18448
This is a huge topic in itself. It is impossible to answer without sitting down with the client. Modern Portfolio Theory would argue against a 1/n-style diversification, with the CFA calling it a behavioural finance bias.
The CFA answer would be: You want to develop an IPS with the client. What are their risk/return objectives? Also look at: time horizon, tax concerns, liquidity needs, legal constaints, and unique concerns.
For example, the client may have specific requirements, such as "no derivatives" or "no negative return in any year more than X%".
Normally for a pension plan you need to figure out what the required return is for the client to meet its pension obligations and start with that. You could propose a portfolio following Asset Liability Management principles. Allocate assets to meet pension needs, any surplus can be actively managed.
Also, beware of correlations between investment assets and the client's business.
These really just scratch the surface. Look at CFA Level 3 material, it goes into more detail.
## Answer by zuiqo (score 3)
https://quant.stackexchange.com/a/18738
Short Update on the specific way we have chosen:
- Have a risky and a safe portfolio, and shift assets over time into the safe one to protect liabilities. The safe portfolio is duration matched and holds Bunds and cash.
- The risky portfolio is multi asset class. Specific allocation is based on a constrained MV optimization on index level. This part is dynamic and will be reallocated quarterly. Implementation using index funds and fund-of-funds, as well as absolute return funds. Put options on the related benchmarks are used for each fund individually to minimize base risk.
- The allocation between risky and safe portfolio somewhat resembles a CPPI concept. First make sure that liabilities are met, then generate some performance. Shifting like this allows more capital to be employed in performance generation, and thus keep risk in check.
I'll keep this open to see other input.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.