Incorporating uncertainty about alternative assets in strategic pension fund asset allocation

Abstract

Recent developments in regulation require pension funds to perform strategic and tactical asset allocation decisions while taking into account their pension liabilities. Sharpe and Tint (1990) show how portfolio theory can be adapted when liabilities enter the portfolio choice problem. The portfolio weights that result in this framework are highly depending on the expected returns that are used as an input for this model. This is an important reason why the framework has not been very popular amongst practitioners. In this article we describe a robust method for asset allocation that takes into account uncertainty about the expected returns on different asset classes and takes into account pension liabilities. We apply this method to a UK pension fund that contemplates investing in alternative assets such as emerging markets equity, real estate, hedge funds, private equity, and commodities.