The basic strategy for pension schemes can, and often has to be, summarised in a few broad principles. In our ‘post-modern' world of investors, there is quite some consensus on the basic investment principles for institutional investors. Unfortunately, there is less attention for the pitfalls when implementing these principles. From my experience as investor for a large pension fund I have tried to shed light on these pitfalls. But first I will briefly describe the underlying principles; these are grounded on economic theory, on common sense or on both.

Any investment policy needs clear objectives. For pension funds the objective is to provide a stream of real annuities from the date of retirement. This objective is the same for DB and DC schemes and for all the hybrids you can come up with. It is essential that the objective will be quantified to determine the risks. What gets measured gets managed! In this case, quantification looks straightforward: the present value of the promised or intended real annuities will do. The discount rate applied should reflect the risk the investor or, in a principal agent relationship, the beneficiaries are willing to take. This all leads off course to liability driven investments (LDI). In recent publications a number of UK consultants try to denounce the concept of LDI. That is completely wrong. From a theoretical perspective the concept of LDI is sound; it is a good proxy for a consumption-based multi period investment problem. The relevant risks in this setting are not only the actual market risks but also the future risks that relate to reinvestment risk, mainly interest rate risk, and the inflation risk. The seminal work of Merton in the 1970s already drew attention to the importance of these ‘state variable' risks.

We have to live in a world where valuations are not only done by economic professionals but also by accountants and actuaries. These professionals often come up with ‘best practices' that might serve the interests of the corporate sponsors, for example stable valuations over time, but are less relevant for risk analysis. The practice of stable valuations was widely applied in the 1980s and 1990s. The tricks were ‘actuarial' valuation of assets and the use of a constant and often unreasonably high discount rate. Apart from giving an often too rosy view of the actual financial situation this practice prevented a clear view on the relevant state of variable risks. With hindsight the interest rate risk, which in a standard pension scheme is huge, has not been sufficiently recognised and therefore has not been managed adequately. The same might happen now with inflation risk especially in countries like the Netherlands where accountants and regulators agree on a valuation based on nominal annuities. As long as the objective is real annuities, the relevant investment target should be these real annuities and not some distorted accounting benchmark. That hasn't worked in the past and won't work in the future.

The idea that there might be an optimal trade-off between risk and return is widely accepted in investment practice. The insights of modern portfolio theory, including the path-breaking work of Harry Markowitz, are key for institutional investors. That is insofar as MPT applies to diversification and elimination of non-systematic risk and it is remembered that it can be achieved in a long-only context. The practice of long-short investing is relatively new in the world of pension funds and is mostly confined to a small part of total assets, the investments in hedge funds. The use of long-short strategies or hedging as part of overall allocation is however gaining momentum. Hedging of exchange risk is now broadly accepted by pension funds in the smaller European countries that face a lot of foreign country risk. The renewed interest in LDI has led to (partial) hedging of interest rate risk, in line with the intertemporal portfolio theory by Merton in the seventies.


The popularity of these portfolio concepts has led to a widespread use of quantitative models that compute the set of efficient portfolios. The techniques are now part of the toolbox of any bachelor degree in investments. A policy paper without reference to this set of efficient portfolios is rare nowadays. The weakness lies in the extensive use of constraints to obtain a solution that fits into the reference set of the decision maker. The use of constraints is recommended to prevent falling into the trap of the ‘error maximising properties of formal optimisation models', see Michaud for the seminal work on this aspect. Constraints might protect you against the inherent weaknesses of formal models. On the other hand, many constraints, especially those that exclude the use of certain instruments or assets, are not functional or just counterproductive.

Expectations play a key role in formal and less formal optimisation models. However, if anywhere, the old adage ‘rubbish in, rubbish out' applies here. Professional investors see themselves as smart investors who are not subject to the fallacies of emotions such as regret and overconfidence. They form their expectations rationally and are free from all kinds of cognitive errors as undue optimism or pessimism; they don't suffer from cognitive dissonance and do not overstate their predictive capabilities and most certainly they do not show herd behaviour. The reality is, however, less bright; the actual behaviour of institutional investors reflects the findings from the Behavioural Finance theory more than those of the rational expectations theory.

The problem is that is not always so obvious; in distressed times there is strong outside pressure to come up with a new strategy that reflects the new reality. This incorporates the most recent view on financial markets, which is then often too pessimistic. We have also observed that most institutional investors were not able to get out of the equity bubble in the late 1990s; at the very end, even the most stubborn value investors had to give in. Coming back to present time, one might wonder whether the current popularity of alternatives and credits are to some degree symptoms of extrapolating past returns and/or herd behaviour.

The standard solution to a multi period investment problem is in the form of a static strategy. A long term asset mix is chosen that reflects the risk aversion of the investor and/or the beneficiaries. Every two or three years one will reconsider the strategy and adjust the asset mix. The result is a discretionary dynamic strategy. One can also opt for a more strictly defined dynamic strategy. Well known are rebalancing strategies that correct for the drift in asset mix over time. An alternative strategy is the ‘buy and hold' strategy, which lets the asset mix drift. The rebalancing strategy seems appropriate in the case of constant relative risk aversion and random price movements of financial assets. The ‘buy and hold' strategy lacks an underpinning from utility theory but performs better in trending markets. There is a third family of dynamic strategies: the ‘stop loss' strategies. For a long-term investor, this type seems less appropriate.

In addition to the adjustment of the asset mix to correct for drift, an investor has to look at the actual wealth accumulation from the perspective of the desired wealth at the end of the planning period. Is this target wealth still within reach or should additional measures be taken? The most appropriate instrument seems the use of additional savings if actual wealth falls short of the planning; if the actual wealth exceeds the plan there is room to reduce savings. For mature pension schemes the use of additional savings to correct for a shortfall in accumulated wealth is not very powerful, to put it mildly. In that case one has to consider either a lengthening of the accumulation period - meaning a postponement of retirement - or a downward adjustment of the retirement benefits, or both.

In general, I would not recommend a change in the risk profile in reaction to a change in the relative financial position. The adoption of a more aggressive asset mix to make up for a shortfall in actual wealth would be a form of gambling. Neither do I see the rationale for a more cautious asset mix in such a situation, as long as the assumption of constant relative risk aversion holds as a proxy for the actual preferences of the beneficiaries. That is not to say that the risk aversion might not change over time. If the scheme matures, or in the case of an individual DC-plan retirement age comes close, the risk absorbing capacity decreases and the relative risk aversion increases. The concept of life cycle investment strategy captures that phenomenon in a rather elegant way.


Investors follow some kind of dynamic strategy, either by design or as a result of discretionary decisions over time. It seems wise to have a clear idea at front of the type of dynamic strategy you might want to follow. In general for long-term investors constant mix or buy and hold strategies are superior to stop loss strategies. The reason is that the probability that the accumulated wealth is ‘under water' at some point in time increases with the lengthening of the time horizon, whereas the probability that the end value exceeds the target increases at longer time horizons. If a stop-loss strategy is in place, the probability that at some point in time one has to sell the risky assets in favour of ‘safe' assets is far from negligible. Usually disaster strikes when asset prices of risky assets are low and those of safe assets are
high: a clear case of ‘buy high, sell low'. The consequence is that the scheme gets trapped in a low return environment. If this kind of pro-cyclical behaviour becomes widespread, for example, as a reaction to regulatory constraints, it has the potential to destabilise financial markets. A case in point is the massive shift to long-term bonds by pension funds and insurers as a reaction to the decrease in interest rates. This has further driven down interest rates and has deepened the crisis for many funds.

That is not to say that one should ignore downside risk altogether but that one should look at it up front and see whether the chosen strategy is sustainable, even in adverse markets. When one cannot stand the heat, one should not enter. Furthermore, it is now possible to buy appropriate insurance against extreme market outcomes at times when the scheme is not yet in a situation of financial distress. House owners know that buying fire insurance might be attractive but that buying insurance is impossible once the house is burning.

The investment principles for a pension scheme should define the objective, the risk profile and the optimal asset mix and last but not least a realistic and sustainable dynamic strategy. Having these principles in place is, however, far from sufficient; there are many pitfalls on the road to success. The probability of falling into one or more of these is high, even if you are well aware of some of them. But don't despair; time heals many wounds.

Jean Frijns is retired, part-time professor and adviser to institutional investors