TY - JOUR
T1 - Separability and Pension Optimization
JF - The Journal of Fixed Income
SP - 60
LP - 67
DO - 10.3905/jfi.2006.670095
VL - 16
IS - 3
AU - Bazdarich, Michael J.
Y1 - 2006/12/31
UR - http://jfi.pm-research.com/content/16/3/60.abstract
N2 - The Separation or Mutual Fund Theorem of finance theory is extended to the case surplus optimization, which is relevant for defined-benefit pension plans and others. While Separation theorems in the standard case have limited empirical applications, separation results in the surplus-optimization case are directly relevant to real-world pension management, because one of the “bases” of the surplus-efficient frontier is the full hedge of the pension plan's liabilities. Surplus-optimal or –efficient portfolios can be expressed as combinations of the full liability hedge and exposure in the overlay with maximum Sharpe ratio. Optimal pension allocation is thus analogous to management of a portable alpha strategy with a “beta” equal to plan liabilities. Our results also indicate that the difference in portfolio weights between asset-optimal (standard) and surplus-optimal efficient frontiers is constant across those respective frontiers, so that the impact of moving from an asset-optimal to a surplus-optimal framework is independent of target returns or risk tolerance. Finally, we explore the details of the full liability-hedge portfolio. In a number of relevant cases, there is no presumption that a dollar of liabilities can be fully-hedged with a dollar of assets, which gives rise to the concept of an effective funding ratio for a pension plan.
ER -