A Probability of Ruin Approach to Optimize Pension Fund Investments

We use a novel concept of ruin probabilities to optimize the asset allocation for various asset classes in a pension fund. We look at a sponsor of a Defined Benefit plan, where current assets plus the expected present value of future contributions are smaller than the expected present value of its liabilities discounted at a “risk free” interest rate; such is the case of thousands of pension plans worth trillions of $USD. This proposal is an alternative to the Solvency II framework.

We present an alternative methodology to classical Asset Liability Management techniques that consider the long-term effects of returns versus volatility, along with funding levels and funding policy. For several combinations of asset allocation, as well as a proper concept and definition of a ”ruin probability”, our approach estimates the portfolio’s probability of ruin. We particularly study the asset allocation of a portfolio that minimizes the probability of reaching a threshold where there is the need to increase contributions or curtail benefits (our ruin concept), under a set of different assumptions of initial funding, future contributions, and financial forecasting models. We will call such portfolio the Minimum Ruin Probability (MRP) portfolio.

Our project also comes as sequel and development of the paper by Hernández-Pacheco and Salgado (2015). We explain the idea and rationale of using the probability of ruin to optimize asset allocation, its relation with other optimization techniques and novel empirical preliminary results.

Find the Q&A here: Q&A on 'Some Novel Investment Approaches'