Managing Institutional Investor Portfolios －LO

With 70 percent of Genentrons pension assets allocated to a health care fund, the correlation between the firms pension assets and profits is likely to be strong. Pyles statement is correct if the health care industry has strong performance, both Genetrons profits and the performance of the pension plan are likely to be high. When a firm is generating high profits simultaneously with high returns, the probability of the firm having to make a pension contribution is low, and if a contribution is made, the amount is likely to be small.

DeGroots statement is incorrect. Since the correlation between Genentrons operations and its pension portfolio is high, if the firms profitability is low, the firm has a higher probability of making a large pension contribution. To avoid the problem of having to make a large contribution at a time when the ability to make contributions is low, companies should seek to have a low correlation between pension assets and firm operations.

In order to have a more stable pension plan surplus, the firm should construct plan liabilities and assets in such a way that changes in pension plan asset valuations are highly correlated with pension plan liabilities, but uncorrelated (low correlation) with the firms core operations. This would ensure that pension fund assets increase in value at the same time liabilities do, keeping funding status unaffected by the firms ability or inability to make contributions.

If pension plan assets are highly correlated with liabilities, but have a zero correlation with firm operations, this would ensure that pension plan assets increase in value at the same time liabilities increase, while the funding status of the plan will be unaffected by the firms ability or inability to make contributions. In the long run, the effect on firm valuation and the firms constituents will be positive due to decreased volatility in fund surplus and the firms earnings. Note that a high correlation between the firms operations and its pension assets means the firm would have a low probability of making pension payments when its ability to fund those payments is high, and a high probability of making pension payments when its ability to fund those payments is low.