Optimal Asset Allocation of Assets in an Open Pension Plan

Abstract

Given the generally long term nature of pension plans, the behavior of the market plays a crucial role in making a pension plan able to meet its obligations. Regardless of the market performance, the structure of the benefits remains the same, unless they are negotiated to be at a different level. In this paper, we studied primarily the impact of market performance on a pension plans ability to meet its obligations. We studied the period from 1974 to 2010 and included asset allocation strategies that varied from allocating 25% to 100% weight assigned to equity portfolios. The goals were to determine which type of asset allocation system is the most efficient across all time horizons. Our results show that it is not necessary to have an overly aggressive posture to equities. Indeed, as assets become more exposed to equities, the efficiency of a portfolio (as measured by Sharpe ratio) declines. We found that an exposure to equity in the range of 35%-50% is sufficient to meet most pension obligations, provided that the plans are fully funded at the outset. We acknowledge and thank the support of all members of the research committee of SOA for their valuable comments.

Keywords: Sharpe Ratio, Risk Aversion, Asset Allocation

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