Defined benefit pension schemes accumulate assets with the ultimate objective of honoring their obligation to the beneficiaries. Liabilities should be at the center of designing investment policies and serve as the ultimate reference point for evaluating and allocating risks and measuring performance. The goal of the investment policy should be to maximize expected excess returns over liabilities subject to an acceptable level of risk that is expressed relative to liabilities. In this article, we argue for the use of a liability-relative drawdown optimization approach to construct investment portfolios. Asset and liability returns are simulated using a vector autoregressive process with state variables. We find that drawdown optimal portfolios provide better downside protection, are better diversified and tend to be less equity centric while providing higher expected returns compared to surplus variance portfolios.

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Keywords asset liability management, assets (accounting), beneficiaries, downside risk, investment policy, liabilities (accounting), optimal portfolio choice, pensions, pensions plans, surplus (accounting), variencies
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Series ERIM Article Series (EAS)
Journal Journal of Asset Management
Berkelaar, A.B, & Kouwenberg, R.R.P. (2010). A liability-relative drawdown approach to pension asset liability management. Journal of Asset Management, 11(2-3), 194–217. doi:10.1057/jam.2010.13