Should we be learning more from pension plan investment frameworks?
Pension plans often use an asset-liability matching investment framework or a blend of total return and asset-liability matching. Here’s a comparison of the two approaches (from an earlier Vanguard article http://www.vanguard.com/international/c ... mentEN.pdf ).
Total return: Application of modern portfolio theory. “Mean-variance optimization is often used to determine asset allocation that’s expected to provide highest risk adjusted return.”
Asset-liability matching: More explicit focus on ensuring assets are sufficient to pay liabilities at a point in time.
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Two paradigms
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| TOTAL RETURN | ASSET-LIABILITY
| | MATCHING
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Rationale | Pension funds are | Asset objective
| long-term investments. | linked explicitly
| Over time, assets will | to funding pension
| outperform liabilities. | benefits.
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Objective | High long-term asset | Stable funding status
| return |
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Risk measure | Volatility of return | Volatility of funding
| | ratio
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Risk-free asset | Cash | Fixed income portfolio
| | perfectly matched to
| | cash flows of liabilities
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Correlation | Maintain portfolio of | Maintain portfolio of
| assets with low | assets positively
| correlation to one | correlated with present
| another | value of plan liabilities
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Liabilities | Are outperformed | Are matched
| |
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Model | Efficient frontier or | Model liabilities, match
| CAPM | liabilities with asset
| | portfolio
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Source: Pension Plan Issues: Investment Framework. Vanguard (see above linked article).
Any views?
Robert
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