Reading 26: Linking Pension Liabilities to Assets－LOS a concerning, allocation

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 7: Asset Allocation
Reading 26: Linking Pension Liabilities to Assets
LOS a: Contrast the assumptions concerning pension liabiity risk in asset-only and liability-relative approaches to asset allocation.

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Which of the following statements regarding the focus of a liability-mimicking versus an asset-only portfolio of pension plans is TRUE? The liability-mimicking portfolio will have a:

A) low correlation with the liabilities and the asset-only approach will focus on investments with a low correlation to assets.

B) high correlation with the liabilities and the asset-only approach will focus on investments with a high correlation to assets.

C) high correlation with the liabilities and the asset-only approach will focus on investments with a low correlation to assets.

D) low correlation with the liabilities and the asset-only approach will focus on investments with a high correlation to assets.

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Answer and Explanation

In the liability-relative approach, the portfolio will be chosen for its ability to mimic the liability (i.e., the portfolio will have a high correlation with the liability). In the asset-only approach, the focus is instead on investments with a low correlation to assets.

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Which of the following is NOT a characteristic of the liability-mimicking portfolio for a pension? The liability-mimicking portfolio:

A) recognizes economic liability.

B) has an exposure to inflation.

C) has an exposure to interest rate changes.

D) is independent of economic growth.

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Answer and Explanation

The liability-mimicking portfolio recognizes that the future liability is subject to market related risk, i.e., it is an economic liability. Market risk is that from interest rate risk, inflation risk, or from an exposure to economic growth.

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Which of the following is NOT a characteristic of the liability-mimicking portfolio for a pension? The process of creating the liability-mimicking portfolio:

A) decomposes the liability into its various exposures.

B) can be applied to insurance liabilities and retirement planning.

C) uses cash as the risk-free investment.

D) creates a benchmark portfolio that has a high correlation with the liabilities.

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Answer and Explanation

Cash is used as the risk-free investment in the asset-only approach. In a liability-relative approach, the risk-free investment is the liability-mimicking portfolio. This portfolio has a high correlation with the liabilities. The pension fund manager constructs this portfolio by decomposing the liability into its various exposures. This approach can also be applied to non-pension obligations, such as meeting insurance liabilities and retirement planning.

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Suppose a corporation has decided to close their defined-benefit pension plan to new employees and open a defined-contribution plan. All new employees will use the defined-contribution plan. All previous employees will have their benefits in the defined benefit plan held constant at its current level. Going forward, they will be entered into the defined-contribution plan. Which of the following assets would be most appropriate for the liability-mimicking portfolio?

A) Nominal bonds.

B) Real return bonds.

C) Small-cap equities.

D) Large-cap equities.

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Answer and Explanation

If the defined benefit pension plan is frozen at its current level, it will have no growth and not be indexed for inflation. Therefore, the most appropriate asset for the liability-mimicking portfolio is nominal bonds.