Risk management for DC pension plans

Abstract: Pension Trustees are constrained in their asset class weightings by the reluctance of pension plan members to accept short-term variability in the portfolio return. Trustees must be risk averse in the sense that they must minimize short term losses, and the aversion will generally be greater for asset classes with the larger weightings. Of course the trustees must maximize returns subject to these short-term constraints. The formulation of this problem in mathematical terms is made difficult by the complexity of defining aversion to variability. In this paper we select a utility function that seems to capture both the aversion to short term variability in an asset class as well as its dependence on the weighting of that asset class in the total portfolio. It turns out that the optimization of the portfolio mix is tractable with this utility definition, and Canadian data is used to illustrate the procedure. The commonly used Markowitz efficient frontier requires the investor to state their “risk aversion ” by specifying tolerable variability in the total portfolio. But our method produces an optimal mix which takes account of the whole distribution of returns in each asset class, and the correlation of returns among classes, in the maximization of utility. This approach should be useful for pension trustees. For Defined Benefit trustees, the inherent aversion to variability is a natural feature of cash flow management. For Defined Contribution trustees, who are investing for the long term, short-term variability would be less of a concern were it not for the traditions of balanced investing and the possible liability presented by short-term losses