Reading 26: Linking Pension Liabilities to Assets－LOS b identify, economic, liability

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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 b: Discuss the fundamental and economic exposures of pension liabilities and identify asset types that mimic these liability exposures.

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A defined benefit pension plan decides to index their benefits to inflation. Meanwhile, the labor force has increased in productivity and profits have soared. Which of the following best describes the changes to their liability-mimicking portfolio? The liability-mimicking portfolio should have:

A) more equities and more nominal bonds.

B) more equities and more real return bonds.

C) fewer equities and more real return bonds.

D) fewer equities and more nominal bonds.

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Answer and Explanation

If the pension plan decides to index their benefits to inflation, more real return (inflation-indexed) bonds should be added to hedge the benefits. If the labor force becomes more productive, wages will increase due to this real growth. This real growth is related to economic growth and is best hedged by equities.

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Which of the following pension plan segment obligations would not be hedged by the liability-relative portfolio? The segment exposure not hedged is that from:

A) inactive participants.

B) future participants.

C) accruals to active participants.

D) future wage growth.

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Answer and Explanation

The payments to inactive participants and the accruals to active participants for past service constitute accrued benefits will be hedged with nominal bonds if they are not indexed to inflation. A pensions future obligations are those arising due to wages to be earned in the future, future service rendered, and future plan participants. The first component is typically hedged with equities, nominal, and real bonds. The latter two components are uncertain and not easily modeled or funded.

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Which of the following defined benefit pension plan segments generates the greatest liability noise? The greatest source of liability noise is that from:

A) inactive participants.

B) active participants.

C) retirees.

D) deferreds.

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Answer and Explanation

Pensions are subject to non-market exposures referred to as liability noise. Inactive participants can be divided into retirees and deferreds. The liability noise from either of these groups is less than that from active participants.