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Dynamic allocation decisions in the presence of funding ratio constraints*

Published online by Cambridge University Press:  10 August 2012

LIONEL MARTELLINI  and
VINCENT MILHAU
LIONEL MARTELLINI*
Affiliation:
EDHEC Business School and EDHEC-Risk Institute (e-mail: lionel.martellini@edhec.edu)
VINCENT MILHAU
Affiliation:
EDHEC-Risk Institute (e-mail: vincent.milhau@edhec.edu)
*
1Author for correspondence. Contact: EDHEC-Risk Institute, 400 Promenade des Anglais, BP 3116, 06202 Nice Cedex 3 France. Phone: +33 (0)4 93 18 34 94. Fax: +33 (0)4 93 18 78 44.
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Abstract

This paper introduces a continuous-time allocation model for an investor facing stochastic liability commitments indexed with respect to inflation. In the presence of funding ratio constraints, the optimal policy is shown to involve dynamic allocation strategies that are reminiscent of portfolio insurance strategies, extended to an asset–liability management (ALM) context. Empirical tests suggest that their benefits are relatively robust with respect to changes in the objective function and the introduction of various forms of market incompleteness. We also show that the introduction of maximum funding ratio targets would allow pension funds to decrease the cost of downside liability risk protection.

Type
Articles
Information
Journal of Pension Economics & Finance , Volume 11 , Issue 4 , October 2012 , pp. 549 - 580
Copyright
Copyright © Cambridge University Press 2012

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Footnotes

*

A previous version of this paper was circulated under the title ‘How costly is regulatory shorttermism for defined-benefit pension funds?’. We acknowledge financial support from the ‘Asset-Liability Management and Institutional Investment Management Chair’, BNP Paribas Investment Partners and the ‘Chaire Produits structurés et Produits dérivés’, Fédération Bancaire Française. We express our gratitude to the editor, Joshua Rauh, and two anonymous referees for extremely useful comments. We thank Noël Amenc, Peter Carr, Nicole El Karoui, Thomas Heckel, Pierre Moulin, Samuel Sender, Frédéric Surry, Volker Ziemann and participants at the Bachelier mathematical finance seminar, the Bloomberg finance seminar, the EDHEC-Risk finance seminar, the University Paris-Dauphine finance seminar, the 6th Madrid finance workshop and the Inquire Europe 2009 seminar for very useful comments. This work has also benefited from fruitful exchanges with the financial engineering team at BNP Paribas Investment Partners. Any remaining error is ours.

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