The theory of LDI

This paper considers the optimal allocation problem for a pension fund. Using the liability portfolio as a numeraire, it shows that the solution involves a three fund separation theorem that provides formal justification to recently introduced liability-driven investment solutions. By Lionel Martellini

Recent difficulties have drawn attention to the risk management practices of institutional investors in general and defined benefit pension plans in particular.What has been labeled “a perfect storm” of adverse market conditions over the past three years has devastated many corporate defined benefit pensionplans. Negative equity market returns have eroded plan assets at the same time as declining interest rates have increased market-to-market value of benefit obligations.

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