Abstract

In defined contribution (DC) pension schemes, the regulator usually imposes asset allocation constraints (minimum and maximum limits by asset class) in order to create funds with different risk-return profiles. In this article, we challenge this approach and show that such funds can exhibit erratic risk-return profiles that deviate significantly from the intended design. We propose to replace all minimum and maximum asset allocation constraints by a single risk metric (or measure) that controls risk directly. Thus, funds with different risk-return profiles can be immediately created by adjusting the risk tolerance parameter accordingly. Using data from the Chilean DC pension system, we show that our approach generates funds whose risk-return profiles are consistently ordered according to the intended design, and outperforms funds created by means of asset allocation limits. (C) 2019 Elsevier B.V. All rights reserved.