Reviewing 2015 AM Written from the insititute.
Pension offers lump sum payout to plan participants over age 50. Ten percent accept. How does the acceptance of this option impact duration of plan liabilities?
CFA says that it “decreases duration of plan liabilities”. An increase makes more sense to me.
-Older individuals have shorter durations vs. younger individuals who have longer durations, correct? When the old participants with shorter durations are removed from the PBO, the remaining individuals are younger, with greater durations, thus increasing the duration of the PBO per my understanding.
Can someone explain this?
Duration can be thought of as the weighted average of your cashflows (In this case, cash outflows) measured in time.
A lump sum payment would cause more cash flows to be required at an earlier date. This would shift more cash flows to an earlier date, thus reducing the weighted average and effectively reducing the duration.
So someone can choose to get a lump sum payout of $100 on year 10 or someone can get $10 a year for ten years starting year 10 through year 20. What duration is longer my man?
I think it is correct to say that in the theoretical case where the lump sum payments were an one off event andand already been been paid out the duration would increase.
When thinking about it in the cfa context, the planned payments will be made earlier as described above which means duration is decreased and liquidity requirements are increased.