Linking Pension Liab to assets

Question 2

15.b: Discuss the fundamental and economic exposures of pension
liabilities and identify asset types that mimic these liability exposures

Answer 2

Duration Management focuses on short-term changes in the liability relative to changes in interest rates.

liability relative management …?

Market exposures: - Inflation interest rate, and economical

Non market exposures ( liability noise) -

plan demographics - Primarly by the number of participants and can be estimated using statistical models

model uncertanity - less predictable and is different for inactive versus active participants.

fixed, not increasing with inflation, making nominal bonds the optimal benchmark;
fully indexed to inflation making real rate (real return) bonds such as Treasury Inflation Protected Securities (TIPS) the optimal benchmark;

The growth in future wages can be decomposed into a portion equal to the rate of inflation and any additional real growth over and above inflation.

Question 3

15.c: Compare pension portfolios built from a traditional asset-only perspective to portfolios designed relative to liabilities and discuss why corporations may choose not to implement fully the liability mimicking
portfolio.

Answer 3

The asset mix that best mimics the liability’s market and non-market exposures will have the lowest possible standard deviation of surplus and is called the liability mimicking portfolio (LMP).

The asset-only approach to defined benefit pension plan management focuses on asset
return versus asset volatility.