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Defining and Measuring Investment Risk in Defined Benefit Pension Funds

Published online by Cambridge University Press:  10 May 2011

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

Keywords

Investment RiskDefined Benefit Pension FundsInvestment StrategiesRisk in Actuarial Applications
Type
Papers
Information
Annals of Actuarial Science , Volume 2 , Issue 1 , March 2007 , pp. 51 - 66
Copyright
Copyright © Institute and Faculty of Actuaries 2007

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