.

Continuous-Time Pension-Fund Modelling

Andrew J.G. Cairns 1 2
Department of Actuarial Mathematics and Statistics,
Heriot-Watt University,
Riccarton, Edinburgh, EH14 4AS,
United Kingdom

Abstract
This paper considers stochastic pension fund models which evolve in continuous
time and with continuous adjustments to the contribution rate and to the asset mix.
A generalization of constant proportion portfolio insurance is considered and an an-
alytical solution is derived for the stationary distribution of the funding level. In the
case where a risk-free asset exists this is a translated-inverse-gamma distribution.
Numerical examples show that the continuous-time model gives a very good ap-
proximation to more widely used discrete time models, with, say, annual contribu-
tion rate reviews, and using a variety of models for stochastic investment returns.
Keywords: continuous time; stochastic differential equation; risk-free rate; contin-
uous proportion portfolio insurance.

1 E-mail:
[email protected]
2
WWW: http://www.ma.hw.ac.uk/ andrewc/
1 Introduction
In this paper we consider continuous time stochastic models for pension fund dy-
namics. The general form of this simple model is:

dXt Xt d t Xt N D Xt B dt
where Xt funding level at time t
Assets/Liabilities at time t
d t Xt real return between t and t dt
over salary growth
N normal contribution rate
D t Xt adjustment to the contribution rate
for surplus or deficit
and B rate of benefit outgo (as a proportion
of the actuarial liability)

(Note that the description of the model given here allows for the distribution of
investment returns to depend upon the funding level.)
Here, it is assumed that the level of benefit outgo is constant through time relative
to the actuarial liability.
Related to the funding level is the target funding level, L, which will normally be
equal to 1 but this need not be the case. This reserve is related to the normal contri-
bution rate, the level of benefit outgo and the valuation rate of interest in excess of
salary growth, v , in the following way:
dL
vL N B 0
dt
That is, if the experience of the fund is precisely as expected then interest on the
fund plus the normal contribution rate will be precisely sufficient to pay the benefits.
Thus B N v L.
Similar continuous time models have been considered by Dufresne (1990). A dis-
crete time version version of the model has been considered in more detail and
in various forms by Cairns and Parker (1996), Dufresne (1988, 1989, 1990) and
Haberman (1992, 1994).
This paper will discuss various special cases of the model. The first case is where
d t Xt does not depend upon Xt and, in effect, reflects a static investment pol-
icy with independent and identically distributed returns. This case has previously
been considered by Dufresne (1990) who showed that the stationary distribution
of the fund size was Inverse Gaussian and here we verify his result using different
techniques.
The second case will consider Continuous Proportion Portfolio Insurance. This is a
special type of investment strategy which holds a greater proportion of its assets in
low risk stocks when the funding level Xt is low. Several sub-cases are investigated
including one in which a risk-free asset exists and one in which it does not. The
latter indicates that selling a particular asset class short could be a problem and as a
consequence certain constraints are put in place. These constraints prevent the fund
from going short on the higher risk assets when the funding level is low and place
an upper limit on the amount by which the fund can go short on low risk assets
when the funding level is high. In all cases, a closed form solution can be found for
the limiting (stationary) density function of Xt . When there exists a risk-free asset,
this distribution is Translated-Inverse-Gaussian (TIG).
Much of the analysis relies on the following result:
Theorem 1.1
Let the continuous-time stochastic process Xt satisfy the stochastic differential equa-
tion

dXt Xt Xt2 1 2
dZt t Xt dt

subject to the constraints on the parameters 0, 0, 2 4 0, 0 and

0.
(a) If 2 4 0, the stationary density function of Xt is

1 x b
fX x k exp 2a tan x x2 1
c
for x
1
where a 2
4 2

b
2
4 2
c
2

where k is a normalizing constant.

(b) If 2 4 0 and X0 b, the stationary density function of Xt is

fX x k x b exp x b for b x

where b
2

2 1

2
2

that is, the Translated-Inverse-Gamma distribution with parameters b, 1 0

and 0 (T IG b 1 ). (If X T IG k then X k 1 Gamma .)
Proof See Cairns (1996).

2 Model 1: Static investment strategy

This model takes the simplest case possible. In the absence of other cashflows the
value of the assets will follow Geometric Brownian motion. Thus

d t Xt d t dt dZt

where Zt is standard Brownian Motion.

In particular investment returns are uncorrelated and do not depend upon the fund-
ing level at any point in time. Such a model is appropriate if the trustees of the fund
operate a static asset allocation strategy: that is, the proportion of the fund invested
in each asset class remains fixed.
The deficit at time t is L Xt and the adjustment for this deficit to the contribution
rate is

D Xt k L Xt

k 1 am is the spread factor, and m is the term of amortization.

This method is sometimes referred to as the spread method of amortization (for
example, see Dufresne, 1988).
In continuous time this model has been considered by Dufresne (1990).
The stochastic differential equation for the fund size is
 dXt dt dZt Xt N B k L Xt dt Xt dt Xt dZt t

where k and k v L.

2.1 Properties of X
Let X be a random variable with the stationary distribution of Xt . (Cairns and Parker,
1996, show that such processes are stationary and ergodic.)
Now Xt falls into the collection of stochastic processes covered in Theorem 1.1 Thus
by Theorem 1.1(b) X has an Inverse Gamma distribution with parameters 1 and
2 2 1
where 2 1 2 and 4 (that is, X Gamma 1 ). For this
to be a proper distribution (that is, one which has a density which integrates to 1)
1 2
we require that 1. This therefore imposes the further condition that k 2 .
Stronger conditions on k are required to ensure that X has finite moments.
The stationary distribution of Xt was found by Dufresne (1990), Proposition 4.4.4,
but here we have derived it in a different way by making use of Theorem 1.1.
Let M j E X j where j is a non-negative integer. Then it is easy to show that for
j 1
j
Mj
2 3 j 1
For j 1, M j is infinite.
Using these equations we see that
k v
E X L
k
k 2
v
E X2 1 2
L2
k k 2
k 21 2
v 2
Var X 1 2
L2
k 2 k 2

Note that it is possible for the process to be stationary but to have an infinite mean.
Using this information we can calculate, for example, Pr X x0 where x0 is the
government statutory limit of 105% of the actuarial liability calculated on the UK
statutory valuation basis. This figure gives a guide to the frequency in the long run
of breaches of this upper limit.
2.2 Hitting Times
The problems described below are included as open problems.
Suppose T inf t : Xt x . Since Xt is stationary it cannot be true that E s XT
E s X0 . If, on the other hand, 0 x X0 y and T inf t : Xt x or y then
E s XT s x Pr XT x s y Pr XT y E s X0 .) Since no closed form
for s x exists this problem must be solved numerically.
The problem can be generalized to allow us to gain further information about a
stopping time T . Suppose we are interested in the first time, T , that the process Xt
reaches some level x or hits an upper or a lower bound (y or x). We can at least in
principle obtain the moment generating function for T by generalizing the approach
described in Section 2.1.
Let Yt f t Xt F t G Xt , which we wish to be a martingale.
Then by Itos formula we have

1
dY FGdt FG dX FG dX 2
2
1 2 2
FG XdZ FG X FG XFG G dt
2

For Yt to be a martingale we therefore require the dt term to be equal to zero. That

is
F t 1 2 x2
G x x G x
F t Gx 2
F t F0 exp t

and G x satisfies:

x2 G x x G x Gx 0

where 2 2, 2 2 and 2 2.

Again, no general form for G x can be found, so numerical solutions seems to

provide the way forward. However, it may be possible to prove qualitative results
regarding the shape of the distribution of T .
3 Model 2: Continuous Proportion Portfolio Insur-
ance
Black and Jones (1988) and Black and Perold (1992) discuss an investment strategy
called Continuous Proportion Portfolio Insurance (CPPI) which is appropriate for
funds which have some sort of minimum funding constraint imposed by either by
law or by the trustees of the fund.
When the funding level is low (A L M) all assets should be invested in a low risk
portfolio (relative to the M). As A L rises above M any surplus and, perhaps more,
should be invested in higher risk assets.
This is in contrast to the static investment strategy discussed in Section 2 which
rebalances the portfolio continuously to retain the same proportion of assets in each
asset class.
Suppose that we have two assets in which we can invest. Asset 1 is risk free and
offers an instantaneous rate of return of 1 . Asset 2 is a risky asset with d 2 t
2 0 (with 22 0). Since asset 2 is risky we have
2 dt 2 dZt . 1 2 and 2
2 1.
Let p t be the proportion of assets at time t which are invested in asset 2 and let
Xt be the funding level at time t. Under the static investment strategy p t p for
all t. Under the CPPI strategy p t depends on Xt only: p t 0 whenever Xt M;
and p t p Xt 0 when Xt M. A strategy which results in p t 1 for some
values of Xt allows for the risk-free asset to be sold short.
We consider the case p t Xt M Xt . Then

dXt p t Xt d 2 t 1 p t Xt 1 dt k v Ldt kXt dt

Xt M 2 dt 2 dZt M 1 dt k v Ldt
k Xt M dt kMdt
Hence

d Xt M c dt a Xt M dt 2 Xt M dZt
where a k 2
c k v L k 1 M
Xt M Inverse-Gamma 1
a
where 21 2
2
 2c
2
2

E Xt M
2
2
Var Xt M 2
2 3

Therefore we have

k v L k 1 M
E Xt M
k 2
2 2
k v L k 1 M 2
Var Xt 2
k 2 2k 2 2

1 2
provided k 2 2 2
From these equations, we see that we require c 0 to ensure that Xt M for all
t almost surely (that is, the risk-free interest plus the amortization effort must be
sufficient to keep the funding level above M). We also require a 0 (that is, k 2)
to ensure that Xt does not tend to infinity almost surely. Finally we can see that the
1 2
variance will be infinite if k 2 2 2.

4 Comparing models 1 and 2

Models 1 and 2 describe two quite different asset allocation strategies and it is,
therefore, useful to be able to compare them and to decide which strategy is better
and when. The following theorem answers this to a certain extent.
Theorem 4.1
Suppose that we have a risk-free asset (with d 1 t 1 dt) and a risky asset (with
d 2 t 2 dt 2 dZ t ).
Under CPPI the mean funding level is E Xt and its variance is C2 Var Xt .
Under a static investment strategy we invest a proportion p is the risky asset and
1 p in the risk-free asset.
There exists p such that under the static investment strategy E Xt (as with
CPPI) and Var Xt 2 2
S C.
Proof See Cairns (1996) but note that the appropriate value of p is M .
Interpretation: In the variance sense, the static strategy is more efficient than CPPI:
that is, given a CPPI strategy we can always find a static strategy which delivers the
same mean funding level but a lower variance.
One example illustrating this result is plotted in Figure 1.
Under CPPI we have 1 0 02 2 0 05 v 0 015 22 0 152, L 1 M 0 7
and k 0 1. This gives rise to E Xt 1 28, Var Xt 0 3132. The mean is rela-
tively high because the valuation rate of interest v appears very cautious. However,
the use of such a cautious basis is not necessarily too far from regular practice.
Under the equivalent static strategy which has E Xt 1 28 we invest 45.3% of the
fund in asset 2 and 54.7% of the fund in the risk-free asset 1. The stationary variance
of the fund size is then found to be Var Xt 0 2432.
The static variance is significantly less than that for CPPI. This is not too evident
from Figure 1, but arises out of the fact that the CPPI density has a much fatter right
hand tail. CPPI also gives a much more skewed distribution.
Now there are various reasons for why we may prefer CPPI to the static strategy.
Principally this will happen when the objective of the pension fund is more than
just to minimize the variance of the contribution rate. For example, there may be
a penalty attached to a funding level which is below some minimum. In the exam-
ple above, if this is anything below about 0.9 then CPPI may be favoured. More
generally some utility functions may result in a higher expected utility for CPPI (in
particular, those which penalize low funding levels).
Conversely there exist utility functions which result in optimal strategies which
are the exact opposite of CPPI. For example, Boulier et al. (1995) maximize the
function

V exp s C t 2ds
0

where C t N D t Xt is the contribution rate at time t.

They found that the optimal strategy was to invest in risky assets when the funding
level is low and to move into toe risk-free asset as the funding level increases. The
rationale behind this is that if there is no minimum funding constraint then: (a) one
should try to reach a high funding level as quickly as possible, no matter how risky
the strategy; and (b) when a high funding position is reached then this should be
protected. Investing in a low risk strategy when the funding level is high will do
two things: (a) protect the low contribution rate; and (b) reduce the risk that if too
much surplus is generated then the benefits will have to be improved.
In practice, one may wish to combine these two extremes by having a bell shaped
asset allocation: that is, one which moves into the risk-free asset if the funding level
 2.0

CPPI
Probability Density
1.5

Static
1.0
0.5
0.0

0.0 0.5 1.0 1.5 2.0 2.5 3.0

Funding Level

Figure 1: Comparison of the stationary densities for the Static and CPPI asset allo-
cation strategies. Static (solid curve): E Xt 1 28, Var Xt 0 2432. CPPI (dotted
curve): E Xt 1 28, Var Xt 0 3132 .

approaches the minimum or if the funding level gets quite high and into more risky
assets if the funding level lies between these two extremes.

5 Model 4: A generalization of CPPI

Section 3 described CPPI in its most basic form. Portfolio A was considered to
be risk free for the purposes of minimum funding, while Portfolio B was a more
risky portfolio offerring higher expected returns. If the funding level (the A/L ratio)
according to some prescribed basis lies below some minimum M then all assets
would be invested on the low-risk asset A. If the A/L ratio is above M then a multiple
c of the surplus assets over this minimum would be invested in the risky asset B.
Given the existence of a risk-free asset A, and provided the level of adjustment for
surplus or deficit is high enough then such a strategy ensures that the A/L ratio never
falls below M, provided it starts above this level.
Here we will generalize this strategy to take account of the fact that often it is
not possible to construct a completely risk-free portfolio (since the nature of the
liabilities means that it is rarely possible for us to match them with appropriate
assets).
Suppose that we may invest in a range of n assets. The values of these assets all
follow correlated Geometric Brownian Motion. Thus asset j produces a return in
the time interval [t, t+dt) of
n
d j t j dt c jk dZk t
k 1

where Z1 t Zn t are independent standard Brownian Motions.

At all times portfolio A invests a proportion Aj in asset j for j 1 2 n, with
the portfolio being continually rebalanced to ensure that the proportions invested in
each asset remain constant.
Portfolio B follows the same strategy but has a different balance of assets Bj nj 1 .
Portfolio B invests in what may be regarded as more risky assets than does portfolio
A.
For portfolio A the return in the time interval [t, t+dt) is

n n
A
d A t j j dt c jk dZk t
j 1 k 1

similarly for portfolio B the return in the time interval [t, t+dt) is

n n
B
d B t j j dt c jk dZk t
j 1 k 1

The matrix C c jk is somewhat arbitrary but has the constraint that CCT V
where V is the symmetric convariance matrix for the n assets.
These equations can be condensed into the following forms:

d A t A dt AA dZA t AB dZB t
d B t B dt BA dZA t BB dZB t
n
A
where A j j
j 1
n
B
B j j
j 1
 AA AB
and if S
BA BB
TV TV
A B
then SST A
TV
A
TV
B A B B

Thus without loss of generality we may work with two assets 1 and 2 instead of the
two portfolios A and B.
At any time a proportion of the fund p t is invested in asset 2. Thus the return in
the time interval [t, t+dt) is

d t 1 pt d 1t pt d 2t
where d 1 t 1 dt 11 dZ1 t 12 dZ2 t
d 2 t 2 dt 21 dZ1 t 22 dZ2 t

In a continuous time stationary pension fund model there is a continuous inflow

of contribution income C t and a continuous outflow of benefit payments B. The
contribution rate is made up of two parts: the normal contribution rate N; and an
adjustment for the difference between the funding level X t and the target level of
L. Thus C t N k L X t .
The stochastic differential equation governing the dynamics of the fund size is there-
fore

dX t X t d t N B k L X t dt

Note that if v is the valuation force of interest then N, B and L are related by the
balance equation 0 dL v Ldt N B dt which implies that N B v L.
Hence

dX t X t d t k v L kX t dt

Generalizing the formulation of Black and Jones (1988) we suppose that

p0 p1 X t
pt
X t

Then (abbreviating X t by X and dX t by dX etc.) we have

 dX p0 1 p1 X 1 dt 11 dZ1 12 dZ2
p0 p1 X 2dt 21 dZ1 22 dZ2
kXdt k v Ldt
p0 21 11 1 p1 11 p1 21 X dZ1
p0 22 12 1 p1 12 p1 22 X dZ2
p0 2 1 k v L dt
1 p1 1 p1 2 k X dt
X X2 1 2
dZ3 t Xdt

where Z3 t is a standard Brownian Motion and

p20 21 11
2
22 12
2

2p0 21 11 1 p1 11 p1 21

22 12 1 p1 12 p1 22

1 p1 11 p1 21 2 1 p1 12 p1 22
2

p0 2 1 k v L
k 1 p1 1 p1 2
This stochastic differential equation for X t is therefore in the correct form for
Theorem 1.1. Thus the stationary distribution of X t is

1 x b
fX x k exp 2a tan x x2 1
c
for x
1
where a 2
4 2

b
2
4 2
c
2
This is true provided that it is not possible to synthesize a risk-free asset out of the
two portfolios. If that is the case then we will have 4 2 0.
An example of this is given in Figure 2. Here we have 1 0 02, 2 0 05,
v 0 02, k 0 1, L 1, 11 0 04, 12 21 0 08 and 22 0 15. The
asset allocation strategy uses p0 0 8 and p1 1. This gives E Xt 1 11 and
Var Xt 0 4392. Figure 2 also plots the density for the equivalent static strategy.
This strategy used a linear combination of portfolios 1 and 2 (with p 0 275) and
gives E Xt 1 11 and Var Xt 0 3432. We see that generalized CPPI appears
to have a similar effect to the more basic form: that is, the distribution has lower
probabilities of low funding levels, a fat tail and is more skewed than the static
strategy.
It should be noted that below a funding level of M p0 p1 the new CPPI strategy
goes short in asset 2 and long in asset 1. Furthermore, there is nothing to stop the
funding level going negative (although the probability that this happens in any one
year is very small). This is because at that point the fund is long in asset 1 and
short in asset 2. If asset 2 performs much better than asset 1 then the funding level
will continue to move in a negative direction. In effect, when the funding level goes
below M, the level of risk increases again. To avoid this problem, Cairns (1996)
considers the case
p0 p1 Xt
Xt whenXt p0 p1
pt
0 whenXt p0 p1

This strategy remains wholly in asset 1 below the minimum and means that Xt will
remain positive with probablity 1.
 1.5

Gen.CPPI
Probability Density
1.0

Static
0.5
0.0

0.0 0.5 1.0 1.5 2.0 2.5 3.0

Funding Level

Figure 2: Comparison of the stationary densities for the Static and Generalized
CPPI asset allocation strategies. Static (solid curve): E Xt 1 11, Var Xt
2
0 343 . Generalized CPPI (dotted curve): E Xt 1 11, Var Xt 0 4392.

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