Surplus Optimization in Defined Benefit Pensions Using the Regime‐Switching Model: Occupational Pension Plans in South Korea*

Abstract

We assume a hypothetical defined benefit (DB) pension plan that reflects the characteristics of the occupational pension in South Korea and propose a surplus optimization strategy using a regime-switching model. Using conditional surplus at risk, we construct an optimized portfolio that limits extreme tail risks. Furthermore, we identify the surplus risk and return conditional on global macroeconomic status using a hidden Markov model. The main results are that (i) the DB pension portfolio should move from principal-protected products to diverse capital market products, and (ii) the DB pension portfolio using the regime-switching model outperforms an unconditional static portfolio.

Dynamic Liability-Driven Investment under Sponsor’s Loss Aversion

“…The realization of optimal investment policies in defined-benefit (DB) pension plans has attracted a great deal of attention in view of pension fund risk management. Regarding DB pension funding, most studies have strongly focused on establishing optimal strategies derived from the well-known mean-variance (MV) framework motivated by risk aversion (e.g., Sharpe and Tint 1990;Ezra 1991;Leibowitz et al 1992;Frauendorfer et al 2007;Xie 2009;Ang et al 2013;Jung et al 2022) as well as the control theory framework (e.g., Cairns 2000;Haberman and Vigna 2002;Miao and Wang 2006;Ngwira and Gerrard 2007;Josa-Fombellida et al 2018). However, as mentioned in Siegmann (2007), these approaches to optimizing investment policies do not take into account the sponsors' tendency to be more sensitive to losses than to gains.…”