Working Paper: CEPR ID: DP6394
Authors: David McCarthy; David K. Miles
Abstract: 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.
Keywords: longevity; pensions; portfolio allocation
JEL Codes: G10; G11; G23; G32; J11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| institutional context (F55) | asset allocation decisions (G11) |
| asymmetries in payoffs (C72) | asset allocation decisions (G11) |
| asymmetries in payoffs (C72) | risk preferences of trustees (D81) |
| assets exceed liabilities (G32) | risk preferences of trustees (D81) |
| strength of corporate sponsor (Z23) | investment risk (G11) |
| likelihood of sponsor making up deficits (Z23) | risk preferences of trustees (D81) |
| investment risk (G11) | asset allocation decisions (G11) |