Determine the proposed asset allocation

Determine the proposed asset allocation


You have been appointed to become the Chief Investment Officer (CIO) of the Tennessee Retirement Plan (TRP). The Fund has been newly established, as the amalgamation of several other pension funds in Tennessee, and provides for the retirement security of the City’s employees. By merging these funds, the trustees hope to create scale, lowering costs and gaining access to new types of assets. The fund is in the midst of an asset allocation process.

The following information is handed to you. As of December 31st 2016 (with all amounts in US Dollar),

– The fund’s assets are 20 billion. The present value of the pension liabilities amount to 18.72 billion (check out the Excel Sheet) indicating that the cover ratio (ratio of assets to liabilities) is 107%.
– The trustees aim at a well-diversified portfolio, in line with the prudent person rule. No asset, except for the bonds to match/insure the liabilities, should be more than 15% of the total portfolio. On the other hand, no weights should be less than 3% of the portfolio, in that case it should be left out.
– The board accepts that taking investment risk in the long term is important, However, the main sponsor of the plan, the Tennessee General Assembly, the state legislature, has made it clear that the state will not provide additional funding when investments hit dire straits.
o The board of TRS therefore has set investment goals for a year horizon equal to:
the accrual of the liabilities, plus
indexation to compensate for inflation, plus
an additional target of 2 per cent to account for buffer, reserves for longevity risk etc.
o The board of TRS has decided that portfolio optimization should be done by optimizing expected return and risk (i.e.. standard deviation). However, for the short term from a risk management perspective, the board steers on the impact of downside risks, working with two scenario’s:
Deflation: factoring in a 40% negative equity shock (all other asset categories
than fixed income are considered as equity) and a 1% interest drop.
Recovery: factoring in a 25% positive equity shock (all other asset categories than fixed income are considered as equity) and a 1% interest rise.
§ Either shock should never be larger than 30 cover ratio points, otherwise the
asset allocation will be “derisked” and the investment goal re-evaluated; i.e. more bonds and less equity like allocations.

– The board has some additional considerations. First, the Board has been comfortable with a 50% hedge of the interest rate sensitivity of the liabilities, although a higher degree of hedging might be possible. Finally, if applicable, 80% of the currency risk in the portfolio is hedged.

Your challenge

The board aims at a fresh start with clear goals. They ask you:

1. To establish a clear return goal for the fund

2. The Board wants to be involved in setting the expected returns, risk and correlation matrix (the so called capital market expectations) What are the historical figures, and what changes would you suggest for a future horizon of 5 years and of 10 years? Why? What academic theories do you have to back this up?

Hint: In one case, we applied Excel Sheets to deal with developing expectations. Review and adapt this sheet for your own purposes.

Develop an appropriate asset allocation proposal for the board. Undertake the following steps:

– Gather return series for the assets under consideration. The Board allows government bonds, corporate bonds, high yield, real estate/REITS, Commodities, Hedge Fund/Quantitative Strategies, and Infratstructure. The following websites might be helpful:
– Damodaran Data Sets:
– Shiller:
– S&P Indices, check, and the tab indices per class,select export in the graphs
– Alternatively, check out Of course, if you find additional data sets and assets, that is fine by the Board, as long as they are widely accepted, and easily managed.

3. Determine the proposed asset allocation to achieve the return goal, within the risk limit, with a ten year horizon. This includes the strategic policy weights, and the ranges in between the policy weights can move. Determine the optimal portfolio compared to the liabilities.

Hint 1: model the liabilities as negative bond, choose a duration in the bond portfolio that comes close to the one of the liabilities, think about the ratio which these two should have in the Solver.

Hint 2: In one case, we applied Excel Sheets for the optimization of the portfolio. Review and adapt this sheet for your own purposes.

4. Discuss the asset allocation for robustnees. What is the resulting duration gap between liabilities and assets? How well is the fund protected in both risk scenario’s? Calculate the impact on the cover ratio of the two risk scenario’s that form the basis for the risk constraints. Does this seem consistent with the investor objectives, and would you suggest loosening certain constraints and if so, why?

5. Embed ESG. Al Gore was a senator for the State of Tennessee and has a great influence on the Board, so sustainability is an important issue. The portfolio which you just have proposed, what opportunities are there to improve the sustainability profile? Keep in mind that the Board is not inclined to add more active investment styles or wants to raise costs.

6. Nothing left out? Given the proposed asset allocation, do you feel that there are risks or potential investment opportunities that have not been factored in? Please be specific about the argumentation and suggestions, and limit the scope to the discussions and literature of the IIM Course.


You have a board meeting coming up. The discussions, although constructive in nature, have lately become somewhat edgy. The financial markets have been jumpy in the past months; while the overall cover ratio has remained rather stable, it is your first appearance in the Board session and you need to convince the trustees that you’ve covered all angles. You will address the question in an essay to the Board.

– For all questions: provide and answer as well as arguments! Remember, you’re writing for informed decision makers.

– The essay should be between 2,500 and 3,000 words, line space 1.5.

– The essay should have separate paragraphs, based on the earlier mentioned questions. Bear in mind though, that the essay should be to convince a board of trustees. So start with a recapitulation of the problem, provide argumentation, and take a critical (academic and practical) view on how the questions are answered. A trustee should without prior knowledge of the questions be able to follow the line of argumentation.

– Add a cover page with the names of the group members.

– Calculations in Excel should be handed in separately, containing the data sets, (amended) calculations, and a print out of the Solver restrictions, if this was used.

– For reference materials, use the materials handed out during the course. You are naturally encouraged to find and use additional material, whether papers, magazine articles or newspaper articles. In that case add the references at the end of the paper (this is not included in the word count). If you’d like to find more, is a repository of academic (working) papers. Add the source of the data in a separate section at the end (also not included in the word count).

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