Dynamic Liability-Driven Investment under Sponsor’s Loss Aversion
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 func...
| Main Authors: | , |
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| Format: | Article |
| Language: | English |
| Published: |
MDPI AG
2024-02-01
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| Series: | Risks |
| Subjects: | |
| Online Access: | https://www.mdpi.com/2227-9091/12/2/38 |
| Summary: | 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. |
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| ISSN: | 2227-9091 |