DISCUSSION PAPER PI-9610 Portfolio Choice Models of Pension Funds and Life Assurance Companies: Similarities and Differences

In this paper, we examine pension schemes and life policies in terms of the option features either implicitly or explicitly contained in them. We argue that this greatly simpli®es the process of managing the asset side of pension fund and life company balance sheets. We show that these options need to be either replicated or hedged with an appropriately determined portfolio of cash market and derivative securities. The natural portfolio choice framework for achieving this is asset-liability or surplus risk management. We use this framework to derive a dynamic asset allocation strategy over the lifetime of a pension scheme which involves switching, according to pre-set criteria, between equities, index bonds and conventional bonds. We also use this framework to derive a procedure for hedging the risk faced by life companies from the exercise of the options embodied in their products. We end the paper with an example that applies our dynamic asset allocation strategy to the case of a de®ned bene®t pension scheme. Pension funds and life assurance companies are the principal long-term investing institutions and as such they will have liabilities of the longest duration. These liabilities will also be similar in nature, although there will be qualitative differences, e.g., life policies provide for such features as policy loan and early surrender options in a way that pension funds do not, and de®ned bene®t pension schemes have options on the invested assets in a way that life policies do not. The greatest systematic risk faced by both sets of institutions arises from mismatches of various kinds between assets and liabilities. For example, to minimize the risks associated with maturity mismatching, the two sets of institutions will tend to hold a substantial proportion of long-term assets, such as equities, property and long-term bonds, in their portfolios; although, given the speci®c nature of the options attached to life policies, life companies will hold a relatively larger proportion of more capital-certain assets, such as bonds, in their portfolios than pension funds.