Managing Pension Assets: From Surplus Optimization To Liability-Driven Investment

In this paper, the author considers an intertemporal portfolio problem in the presence of liability constraints. Using the value of the liability portfolio as a natural numeraire, he finds that the solution to this problem involves a three fund separation theorem that provides formal justification to some recent so-called liability-driven investment solutions offered by several investment banks and asset management firms, which are based on investment in two underlying building blocks (in addition to the risk-free asset), the standard optimal growth portfolio and a liability hedging portfolio.