Asset Allocation Driven by Liabilities: Application to the Icelandic Pension System

In conventional portfolio management returns are maximised subject to given risk levels. In this framework the only variables of relevance are risk and returns and their interrelationship as expressed in terms of the efficient frontier. It is increasingly the view of investment managers and regulators that pension fund investment strategies need to take their liabilities into consideration when constructing investment portfolios. In this paper we compare the conventional portfolio management approach to asset allocation which aligns investment strategies to a defined liability index. We consider a numerical example based on the Icelandic public sector pension obligation index. A comparison between the conventional risk-return focused approach and the one that seeks to align investment strategies to liabilities shows that the latter approach provides superior performance on market data covering the historical time period from Jan. 2003 to Jan. 2012. The study shows that the liability driven approach performed better in the market downturn in the second half of 2008. Also, a portfolio constructed around liabilities recovered quicker in the years following the market crash.