Prospect Theory and Pension Funds

Interesting interviews with Daniel Kahneman were recently posted, about prospect theory and other key developments in behavioral finance.

According to Thayer Watkins, Daniel Kahneman and Amos Tversky coined the phrase “Prospect Theory” for their studies of how people manage risk and uncertainty,  “for no other reason than that it is a catchy, attention-getting name”. Kahneman and Tversky demonstrate that people’s attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. When choosing between profit opportunities, risk aversion prevails. On the other hand, when confronted with loss making alternatives, people often choose the risky alternative. Although prospect theory is a few decades old, there is still plenty of ground to be covered for pension fund and institutional investors. Just some hypotheses based on prospect theory that need to be explored:

  • An active manager with positive alpha will become risk averse, locking in his profits, while the opposite is true with negative alpha. If this this is the case, then prospect theory is a more intuitive explanation of the disappointing results for active managers. In the selection and monitoring of active management this should be a key element.
  • Pension fund trustees, when confronted with underfunding, will increase their risk instead of downscaling it. It would therefore make sense to make the risk budget for a pension fund board rules based, with an inverse relationship between cover ratio and risk budget. This is however still the exception, rather than mainstream.

If you have more suggestions on how to fruitful explore prospect theory for pension funds, please let us know!

About Alfred Slager

Alfred Slager is professor of pension fund management at TiasNimbas Business School, and director of CentER Appplied Research at the Tilburg School of Economics and Management. His expertise includes international financial services, with a particular interest in investment management and pension funds. He regularly teaches courses to investment managers and pension fund trustees. Prior to this he worked as Chief Investment Officer at Stork Pension Fund, as investment strategist and policy advisor at PGGM Investments, and as manager research and investment manager at Fortis Investments. Slager regularly publishes on pension and investment management subjects and teaches executive courses for pension fund trustees.
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One Response to Prospect Theory and Pension Funds

  1. Joost Arkesteijn says:

    Dear Alfred,

    Currently I am writing my thesis on risk preferences of active pension participants. If it is possible to assess the preferences of participants, it is easier for the board of trustees to implement an investment policy. I am aware of the fact that risk preferences are hard to measure and that individuals suffer from behavioral biases. The thesis is based on survey questions among active participants in differnt pension funds. The pension payoffs and risks are illustrated graphically, in such a way that it is understandable also for employees without any financial knowledge. Based on their choices in the survey, risk preferences of active members are measured.

    One effect that is examined is whether the coverage ratio of pension funds influences the risk attitude of participants. The findings of Kahnemann and Tversky: strong loss aversion and risk-seeking over losses, might also be found for active pension members. Then they would prefer a higher risk profile of their pension fund when coverage ratio is low, and a more defensive portfolio if the coverage ratio is high. What would these preferences mean for the board of trustees, how should the board of trustees react to these preferences of their members? Especially when the board of trustees also have strong investment beliefs on mean reversion of the market. For them it is really tempting to hold a risky portfolio, given the low interest rates and stock declines on capital markets. You would propose an inverse relationship between the risk appetite and coverage ratio, but what if the risk preferences of pension participants are the opposite? Should the Dutch central bank set strict procedures to prohibit pension funds for taking extra risks in case of underfunding? Would these procedures not have disturbing effects on the financial markets, for instance speculators are likely to speculate against assets if they know that pension funds have to take on less risks in their portfolio?

    I am really curious about your opinion on how the risk preferences of participants should influence the investment policy and beliefs of the board of trustees. I think that examining the effect of the coverage ratio on the risk appetite of pension participants can give fruitful insights in examining prospect theory and pension funds. I can keep you updated about our research if you are interested, just let me know.

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