R14 - Linking Pension Liabilities to Assets

Question 1

Liability relative approach to ALM?

Answer 1

decompose liability exposures and match assets to that

Question 2

Pension fund: How to hedge benefits not indexed to inflation?

Answer 2

use nominal bonds to hedge term structure risk (i.e. match specific assets to payout timing)

Question 3

Pension fund: How to hedge benefits that are indexed to inflation?

Answer 3

use inflation-indexed bonds to hedge inflation risk (real rate real return bonds)

Question 4

Pension fund: How to hedge benefits correlated to future growth in firm and economy?

Answer 4

use equities to hedge economic growth risk

Question 5

How to hedge accrued benefits?

Answer 5

if not inflation indexed: nominal bonds

if inflation-indexed: real-rate bonds

Question 6

How to hedge future benefits?

Answer 6

current wage level: mimic using nominal bonds

inflation: real rate bonds

wage increases higher than inflation: use equity

Question 7

Risk factors not mimicked?

Answer 7

future service to company
future entrants
Liability noise:
-plan demographic changes
-model uncertainty

Question 8

Compared to asset only approach, liability relative will:

Answer 8

• hold less equity
• lower return/cost more (b/c company needs to put more in)
• surplus less volatile

Question 9

Liability relative construction:

Answer 9

Portfolio composition:

• long duration bonds
• inflation-indexed bonds
• equities
• derivatives

Using derivatives:

• can use to mimic characteristic
• equity contracts for equity exposure
• bond contracts to adjust for nominal bond exposure