inflation and plan benefits hold, better, benefits

John10

if plan benefits are not inflation indexed, is it better to hold real rate bonds or nominal rate bonds?

pennyless

I agree with janakisri, but can't seem to make sense of the solution...


Solution to CFAI 2010 Mock Exam problem 3 Part B answer for CarbX Corp:

"The CarbX pension plan is frozen, so there is no need for equity. Because there is no inflation indexation, the accrued benefit liability is the ultimate liability of the plan. This liability can be mimicked entirely with nominal bonds. This is accomplished by a sale of equities and purchase of nominal bonds"

oneboy

If benefits are not inflation indexed, why would you hold real rate bonds (which are inflation indexed)?

see schweser book 2 page 55 paragraph 4

wake2000

even if benfits are not indexed, but have active members, you may want to hold real return bonds for the wage inflation of the active members not the inactive members. That was on the 2010 CFAI mock.

bodhisattva

but in the question above, it says the plan is frozen. doesnt that mean there is no more wage increases?

ohai

In any case, real bond is better off ? right ? I am confused by Solution to CFAI 2010 Mock Exam problem 3 Part B.

liangfeng

nominal pls

if the nominal value of benefits is not indexed to inflation, you want to meet these liabilities with assets that are not indexed to inflation either, nominal bonds

Iginla2011

There is confusion here.

The key of the question is how to mimic the plan benefits if it is not inflation-indexed. Pls be noticed that you are in the perspective of a plan manager not the beneficiary.

For a plan manager, you have to control the risk from deviating from the benchmark. The plan benefit for retired people is fixed in amount. The future annuity payment is fixed. This is similar to the coupon payment of a nominal bond. Thus, nominal bond best mimic the liability

NakedPuts00

1 if the plan is frozen, and benefit is not inflation indexed NOMINAL
2 if the plan is frozen, and benefit is inflation indexed REAL
3 if the plan is not frozen, and benefit is not inflation indexed BOTH
4 if the plan is not frozen, and benefit is inflation indexed REAL

With number 3, you hold accrued amount and future amount based on current wage in nominal, you then will hold the future amount from wage increases in real as wage growth will track closely with inflation.

mik82

not indexed to inlation = nominal

indexed to infation = both real and nominal

future wage inflation = real bonds

future wage growth = equities