Correspondence: Wilma de Groot, Robeco Quantitative Strategies. E-mail: w.de.groot@robeco.nl

¹is Senior Researcher at Robeco's Quantitative Strategies Department in Rotterdam and Guest Lecturer at Erasmus University Rotterdam, The Netherlands. She obtained her Master of Science degree in econometrics from Tilburg University, The Netherlands.

²is Assistant Professor in Finance at the Erasmus School of Economics in Rotterdam and Associate Member of the Erasmus Research Institute of Management. He is also a senior researcher at Robeco's Quantitative Strategies Department and board member of Stichting Pensioenfonds Robeco. He obtained his PhD in finance at the CentER Graduate School of Tilburg University, The Netherlands.

Received 30 November 2007; Revised 30 November 2007.

Abstract

We present an asset allocation framework for pension funds in which they can take pension liability risk and uncertainty about future expected asset returns explicitly into account. This framework recognised the liability hedging properties of assets that correlate positively with changes in the market value of pension liabilities. In addition, uncertainty about the expected returns, especially on alternative asset classes, can be taken into account to arrive at realistic and acceptable asset allocations compared with standard portfolio optimisation models. The empirical examples for pension funds in the United Kingdom indicate that for modest assumptions on expected returns of alternative assets ranging between two and three per cent above pension liabilities, the optimal portfolio allocation to alternatives ranges between 15 and 30 per cent.