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An Analysis of the Hedging Approach to Modelling Pension
Fund Liabilities

John Randall and Stephen Satchell

John Randall is a postgraduate student at Birkbeck College, Univ. of
London. Stephen Satchell is a Fellow of Trinity College, Cambridge and
a Visiting Fellow in finance at the Department of Economics,
Birkbeck College, Univ. of London; Satchell is also UK representative
for the US-based Pension Research Institute (PRI).


This paper is an econometric study of which asset classes are most
eligible for hedging pension fund liabilities. Analysis is carried out by
determining what combination of returns from holding equity, conventional
gilts, index-linked gilts, treasury bills and commercial property would have
matched changes in annual pension payouts. This is achieved by estimating
a ``pension hedge portfolio'' under the restrictions that the coefficients,
here interpreted as portfolio weights, are non-negative as well as add
to one. This portfolio is then compared, in a mean variance framework,
with other portfolios in the main asset classes. Although this approach
has limitations, it has produced some interesting results. The analysis
over the period from when index-linked gilts became available suggests
that the pension hedge portfolio should be composed mainly of index-linked
gilts, though equity appears to have the most significant coefficient. The
analysis excluding index-linked gilts suggests, however, that the hedge
portfolio should be composed mainly of conventional gilts.

KEYWORDS: financial econometrics; 1995 Pensions Act; MFR;
mean variance analysis; pension fund liabilities; statistical hedging

ISSN 1367-580x.