An Introduction to Stochastic Pension Fund Management

Andrew Cairns


In this paper, we consider models for pension plans which contain a
stochastic element. The emphasis will be on the use of stochastic interest
models, although we will also consider stochastic salary growth and
price inflation. The paper will concentrate primarily on defined benefit
pension plans. In doing so we will look at how the size of the fund and
contribution rate vary through time and examine how these are influenced
by factors within the control of a plan’s managers and advisers. These
factors include the rate at which surplus is amortized; the period between
valuations; the delay between the valuation data and the implementation of
the new contribution rate; and the asset allocation strategy.

The paper will stress the importance of having a well defined objective for a
pension plan; optimal decisions and strategies can only be made when a well
defined objective is in place.

The paper will also consider, briefly, defined contribution pension plans. The
primary decision here relates to the construction of suitable investment strategies
for individual members. Again, a well defined objective must be formulated before
a sensible strategy can be designed. Finally, computer simulation methods will
be discussed.

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