Linking Pension Liabilities to Asset

Asset-only approach:

1. Maximize return
2. Ignored the fact that liabilities are subjected to inflation, interest rate and economic risks.
3. Risk-free investment is the return on cash.

Liabilities-relative approach (liabilities mimicking approach):

1. Mimic the liability
2. Risk-free investment is the one with correlation=1 with liabilities

Exposures: Need to decompose the liabilities exposures to meet the short term and long term risk. Cannot just use duration as pension has a long time horizon.

Non-active participants (retired and deferred) – payment is fixed (unless indexed to inflation then need inflation-indexed bond)

Active participants: also have fixed past benefits like non-active ones. These together called accrued benefits.

Future Wage Liabilities – PV of future wage related benefits: real growth + inflation part

Real Growth: due to increase in productivity and thus reflected in GDP and stock

Therefore, liabilities-mimicking portfolio is Stock + nominal bonds

Future benefits:

1. Future wages
2. New entrants – Not Funded
3. Future service rendered – linked to future wage growth

Liabilities noise

1. Plan Demographics
2. Model uncertainty

e.g. retiree mortality rate – cannot be hedged

e.g. deferred mortality rate and retirement age (timing and amount, longevity risk): retired sooner: less amount paying for longer period

Liabilities mimicking portfolios:

Derivatives, Equity, inflation-indexed bond and nominal bonds