Hostname: page-component-78c5997874-ndw9j Total loading time: 0 Render date: 2024-11-02T20:27:51.133Z Has data issue: false hasContentIssue false

Defining and Measuring Investment Risk in Defined Benefit Pension Funds

Published online by Cambridge University Press:  10 May 2011

S. F. Whelan
Affiliation:
School of Mathematical Sciences, University College Dublin, Ireland., Email: [email protected]

Abstract

A formal definition of investment risk in actuarial investigations is given. Case studies estimating the investment risk associated with different investment strategies for defined benefit pension funds using historic market data are presented. It is shown that a few decades ago, when bond markets only extended in depth to 20-year maturities, the investment risk of investing in equities was of the same order of magnitude as the investment risk introduced by the duration mismatch from investing in bonds for immature schemes. It is shown that now, with the extension of the term of bond markets and introduction of strippable bonds, the least risk portfolio for the same pension liability is a bond portfolio of suitable duration. It is argued that investment risk voluntarily undertaken in defined benefit pension plans has grown markedly in recent decades, at a time when the ability to bear the investment risk has diminished. Investment risk in pension funds is quite different to investment risk for other investors, which leads to the possibility that current portfolios are not optimised — that is, there exist portfolios which increase the expected surplus without increasing risk. The formalising of our intuitive concept of investment risk in actuarial applications is a first step in the identification of more efficient portfolios.

Type
Papers
Copyright
Copyright © Institute and Faculty of Actuaries 2007

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Arthur, T.G. & Randall, P.A. (1989). Actuaries, pension funds and investment. Journal of the Institute of Actuaries, 117, 149.CrossRefGoogle Scholar
Barclays Capital (2003). Equity Gilt Study 2003. 48th Edition. 54 Lombard Street, London.Google Scholar
Black, F. (1980). The tax consequences of long-run pension policy. Financial Analysts Journal, 36, 2128.Google Scholar
Day, T. (2003). Financial economics and actuarial practice. Presented at the Society of Actuaries Symposium ‘The Great Controversy’, Vancouver, Canada, June 2003. Paper available at www.soa.org/sections/pension_financial_econ.htmlGoogle Scholar
Dimson, E., Marsh, P. & Staunton, M. (2004). Global investment returns yearbook 2004. ABN-AMRO and the London Business School.Google Scholar
Exley, J., Mehta, S. & Smith, A. (1997). The financial theory of defined benefit pension schemes. British Actuarial Journal, 3, 835939.Google Scholar
Gordon, T. & Jarvis, S. (2003). Financial economics and pensions actuaries — The U.K. experience. Presented at the Society of Actuaries Symposium ‘The Great Controversy’, Vancouver, Canada, June 2003. Paper available at www.soa.org/sections/pension_financial_econ.htmlGoogle Scholar
Hill, J. (2003). Submission on the relationship between pension assets and liabilities. Paper presented to the Staple Inn Actuarial Society.Google Scholar
Loretan, M. & Phillips, P.C.B. (1994). Testing covariance stationarity of heavy-tailed time series. Journal of Empirical Finance, 1, 211248.Google Scholar
McLeish, D.J.D. & Stewart, C.M. (1987). Objectives and methods of funding defined benefit pension schemes. Journal of the Institute of Actuaries, 114, 155199.Google Scholar
Mitchell, B.R. (1988). British historical statistics. Cambridge University Press.Google Scholar
Modigliani, F. & Miller, M.H. (1958). The cost of capital, corporation finance and the theory of investments. American Economic Review, 48, 261297.Google Scholar
Sharpe, W. (1976). Corporate funding pension policy. Journal of Financial Economics, 3, 183193.Google Scholar
Speed, C., Bowie, D.et al. (2003). Note on the relationship between pension assets and liabilities. Paper presented to the Staple Inn Actuarial Society.Google Scholar
Sutcliffe, C. (2005). The cult of the equity for pension funds: should it get the boot? Journal of Pension Economics and Finance, March, 5785.Google Scholar
Tepper, I. (1981). Taxation and corporate pension policy. Journal of Finance, 36, 113.Google Scholar
Whelan, S. (2003). Promises, promises: defined benefit pension schemes in a cynical age. Irish Banking Review, Winter, 4862.Google Scholar
Whelan, S. (2004). Measuring investment risk in pension funds. Society of Actuaries in Ireland, 24 February 2004 (available at www.actuaries.ie). A U.K. version of the paper was delivered on 27 July 2004 at Staple Inn, London to a joint meeting of the U.K. Actuarial Profession, INQUIRE, and U.K.SIP.Google Scholar
Whelan, S. (2005). Discussion on equity risk premium: expectations great and small, by Derrig, R.A. & Orr, E.D. North American Actuarial Journal, 9(1), 120124.Google Scholar