Optimal asset allocation of pension funds under a value-at-risk constraint

Abstract

Pension funds must consider both liabilities and assets simultaneously from the perspective of Asset-Liability Management (ALM) to ensure financial soundness. In the context of such ALM schemes, this study presents an optimal portfolio strategy that maximizes the pension fund managers’ utility score as measured by the funding ratio. Our model includes a Value-at-Risk (or shortfall) constraint at the end of the investment horizon. We extend the model in Kraft and Steffensen (2013) to a model with multiple risky assets. Our examples demonstrate that optimal fund managers with high risk-aversion should increase their investment proportions in risky assets when the funding ratio is slightly below the target value, but should first reduce their risky investment and maintain a certain level if the funding ratio is far away from the target value. In addition, as the correlation coefficient between risky assets decreases, the optimal risky proportions increase and their gap decreases. We can interpret this to mean that the stronger the negative correlation is, the stronger the hedging effect between the risky assets is.