Optimal Investment Strategies and Performance Sharing Rules for Pension Schemes with Minimum Guarantee

Abstract: There is a potential conflict of interest between a pension fund sponsor and future pensioners when they share unequally in the pension fund performance. Thus when a scheme offers a yearly guaranteed minimum return to pensioners, as is presently the case with German Pensionskassen, the managers cannot afford to invest in risky assets and consequently, pensioners end up with safe but very low expected returns. We examine optimal investment strategies for fund managers under alternative profit sharing rules and seek the rules that are most beneficial to pensioners. We find the current yearly performance sharing rule imposed on Pensionskassen could be tilted in favor of managers without impairing the welfare of pensioners. We also find that the welfare of pensioners would be greatly enhanced if the guaranteed minimum return were applied to cumulative returns since inception of the scheme rather than to yearly returns. The small ensuing credit risk of pensioners on fund managers could be kept to a minimum by proper regulation; this would push fund managers to adopt safe constant proportionality portfolio insurance (CPPI) style investment strategies.