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Dynamic Liability-Driven Investment under Sponsor’s Loss Aversion

Author

Listed:
  • 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)

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.

Suggested Citation

  • Dong-Hwa Lee & Joo-Ho Sung, 2024. "Dynamic Liability-Driven Investment under Sponsor’s Loss Aversion," Risks, MDPI, vol. 12(2), pages 1-14, February.
    • Handle: RePEc:gam:jrisks:v:12:y:2024:i:2:p:38-:d:1338348
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    References listed on IDEAS

    as
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