Linking Pension Liabilities to Asset

Question 1

a contrast the assumptions concerning pension liability risk in asset-only and liability-relative approaches to asset allocation;

Answer 1

Asset only takes no consideration of the liabilities and assumes these liabilities are not exposed to market related risk. However they are and go unrewareded in an asset only approach.
Pg 456 table

Question 2

Exposures of Pension liabiltiies

Answer 2

Market Related
Non market related
Easy to understand by diving the plan participants in demographic groups

Question 3

Market Related

Answer 3

1. Inactive Participants
   Who? Currently receiving the pension plan benefits or who have left the firm but have not yet started receiving the benefits.
   Fixed Payment except if it is inflation linked.
   Exposure: Term structure
   Mimic Portfolio: Nominal Bond portfolio/ Real and nominal bonds (incase the liability is inflation linked)/ inflation linked bonds (one for one inflation indexation.

2. Active Participants 
Who? Current employees 
Two benefits 
Exposure: Term structure 
Accrued: Past services and wages earned 
Fixed payment except if linked to inflation 
Mimic Portfolio: Nominal Bonds 

b.Future: Future services and wages
- Future wages
Exposure: Inflation Growth and Term Structure- Future wage liability - accrued benefit liability + Future wage liability
Two components - future inflation –> Real bonds till until retirement and nominal bonds after retirement
real wage growth–> Equities + Nominal bonds

• Future Services - linked to wage growth. However this is not considered in the funding target and hence should be excluded from investment benchmark

C. Future Participants:
Rarely considered and hence not to be included

Question 4

Non market related exposures

Answer 4

uncertainity related to non-market exposure is termed as Liability Noise
Two components
- plan demographic experience differing from actuary’s model given that the underlying probabilities are certain
- model uncertainity - underlying probabilities are uncertain

Inactive Participants:
a. Retirees:
- Mortality rate - living longer than expected more benfits or vice versa
- difficult to hedge
b. Deferred’s
- when will retire and start receiving benefits
Active Participants:
withdrawal, disability, retirement - large uncertain - larger liability noise - less hedge able

Question 5

Linking Assets and Liabilities via fundamental factors

Answer 5

Economic and Fundamental Factos: 
Real risk free return, 
Rate of inflation 
Risk premium 
Rate of growth

Question 6

Steps for modelling

Answer 6

Step 1:
Determine the factors involved
Real risk free return - Tbill minus inflation proxy
Rate of inflation change in consumer price index
Risk premium - historical analysis with forward looking estimates
Rate of growth - relation of overall economy and stock market

Step 2: Setting Asset and Liabilities Sensitivities
See page 465-467

Question 7

Desgining Investment Policy Relative to liabilities

Answer 7

• Liability mimicking portfolio - low investment risk
• not provide the expected return and hence future service benefits and future participants are defeased by cash contributions
• should be used only a way to measure
  Other solutions to minimise the unrewarded risk versus liabilities
  Hedge the liability
  Focus the remaining capital on efficient return generation

Question 8

Traditional V liability approach

Answer 8

The traditional approach typically leads to 60%–70% equities with the remainder in short and immediate duration nominal bonds. The liability relative approach, on the other hand, leads to investing in long duration nominal bonds, real rate bonds, equities and derivatives to hedge the liability, with the remainder invested in well-diversified return focused component.”