Portfolio Decisions within a Generalized Funding Ratio Framework

Abstract

The common practice of setting a fixed risk/volatility limit and then choosing the portfolio with the highest return may not adequately account for key considerations such as the fund’s surplus status, required success probability versus critical goals, or the need for return-sensitive downside risk limits. A wide range of behavioral choices that are seen in practice are better understood when investment objectives are viewed in the context of a generalized funding ratio that incorporates these considerations. One natural objective is to find the portfolio with peak success probability versus a basic return target. Another involves seeking the highest return available with a given probability of assurance (e.g., 60%). The combination of such criteria, which depend on the interplay of risk-adjusted returns and return-sensitive risk limits, typically results in a narrow range of portfolio choices. Moreover, the range expands or contracts in accordance with the projected level of rates/returns. By explicitly focusing on various definitions of success within a funding ratio context, this article shows the best risk-balanced portfolio generally falls well below the highest return and/or the standard risk limit.