Dynamic Liability-Driven Investment under Sponsor’s Loss Aversion

Dong-Hwa Lee and Joo-Ho Sung ()
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Dong-Hwa Lee: Pension Research Division, National Pension Research Institute, Sejong 30116, Republic of Korea
Joo-Ho Sung: School of Management, Kyung Hee University, Seoul 02447, Republic of Korea

Risks, 2024, vol. 12, issue 2, 1-14

Abstract: This paper investigates a dynamic liability-driven investment policy for defined-benefit (DB) plans by incorporating the loss aversion of a sponsor, who is assumed to be more sensitive to underfunding than overfunding. Through the lens of prospect theory, we first set up a loss-aversion utility function for a sponsor whose utility depends on the funding ratio in each period, obtained from stochastic processes of pension assets and liabilities. We then construct a multi-horizon dynamic control optimization problem to find the optimal investment strategy that maximizes the expected utility of the plan sponsor. A genetic algorithm is employed to provide a numerical solution for our nonlinear dynamic optimization problem. Our results suggest that the overall paths of the optimal equity allocation decline as the age of a plan participant reaches retirement. We also find that the equity portion of the portfolio increases when a sponsor is less loss-averse or the contribution rate is lower.

Keywords: liability-driven investment; defined-benefit pension plan; loss aversion; prospect theory (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2024
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