When deciding which to allocate towards a pension, what are the deciding factors? I would have thought it was whether or not the liabilities are inflation indexed or not, but I think my logic is wrong.
that is what the book says. No Inflation index -> Nominal bonds Inflation Indexed - Real Bonds.
Basicallywe can use two approaches towards managing Pension Plans: 1) Asset only approach 2) Liability relative (ALM) approach. Curriculum endorses ALM Now we have to segregate Pension liabilities into Active & Inactive lives (Retirees). Acrrued benefits can be divided into already 1) Accrued benefits to Inactives (for their Past services) & to Active (again for their Past services- active means still working yet to receive benefit once they retire). So benefits are fixed unless inflation indexed. If fixed benefits - then Nominal bonds If indexed to inflation benefits - then Inflation indexed bonds (may be TIPS) 2) Future benefits to Active lives (for their future services) Future benefits to be earned in future. Given growth rate in wages we can determine expected amount. Growth rate in wages should be in the form of wage increases due to inflation & real increase (due to increase in labor productivity - GDP growth). Unless benefits are indexed, the portfolio should comprise of Nominal Bonds (Inflation indexed bonds if inflation hedged benefits are promised) & equities (to take care of real growth in wages). 3) Future benefits yet to rendered by active lives & NEW ENTRANTS…these are not typically funded & modeled So Active - accrued & Inactive - accrued are usually fixed so Nominal bonds will dominate the portfolio. More the workforce is towards retirement more nominal bonds will be used to mimic liability structure. Any other views/clarification?? Please share