Research Discussion Papers, Bank of Finland
No 9/2010:
Risk-based classification of financial instruments in the Finnish statutory pension scheme TyEL
Antti J Tanskanen ()
, Petri Niininen and Kari Vatanen
Abstract: Sufficient solvency of a pension insurance company
responsible for defined-benefit pensions guarantees that the pensions are
paid regardless of turbulence in the financial market. In the Finnish
occupational pension system TyEL, the required level of solvency capital
(solvency limit) and its computation are specified in the statutes. Before
the solvency limit can be determined, financial instruments must be
classified into the five statutory asset classes based on risk. The
solvency limit is computed on the basis of this classification and the
average return, volatility and correlation parameters defined in the
statutes. The solvency limit framework is formulated in the spirit of
Markowitz portfolio theory and implicitly assumes that returns follow
Gaussian distributions. This, however, is not actually the case with many –
if not most – financial instruments. Similarly, it is not obvious how to
handle illiquid assets, those with short time series, and which collection
of financial instruments can be combined into a single asset
(portfoliocation) for the purpose of classification. In this study, we
propose two methods of handling these issues: (1) a decision tree-based
method; and (2) a Bayesian method. We show how fat tails of return
distributions are taken into account in the classification process, and how
qualitative assessment of risks is combined with quantitative
classification of financial assets. Coupled with suitable data
transformations, both proposed methods provide efficient and suitable bases
for asset classification in the TyEL pension scheme.
Keywords: Bayesian methods; classification; solvency; non-Gaussian return distributions; TyEL occupational pension scheme; (follow links to similar papers)
JEL-Codes: C11; G22; G23; G28; G32; (follow links to similar papers)
35 pages, April 28, 2010
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