Coming Up Short: Managing Underfunded Portfolios in an LDI-ES Framework

Abstract

The authors present a liability-directed investment (LDI) rebalancing framework that is based on expected shortfall (ES), denoted as LDI-ES, to prescribe remedies for an underfunded portfolio. Investors endowed with some current wealth optimize their target wealth at the end of N periods, subject to their tolerance for shortfalls from that target wealth. The authors contrast LDI-ES rebalancing with fixed-proportions rebalancing, in which portfolio allocations are rebalanced to ratios, such as 60:40, at the beginning of each of N periods. They consider critical issues of underfunding, in which no portfolio can meet the shortfall constraint, as well as the effectiveness of portfolio infusions in resolving underfunded situations relative to other measures, such as increasing risk, cutting back on target liabilities or goals, and extending the portfolio horizon.