2010 essay exam Q3-A

In 2010 exam Q3 in the answers they mention:

“In an inflationary environment, a plan not inflation-indexed would most likely grow its nominal asset base faster than its pension liability as payments to current retirees will not increase. Lower liabilities, as compared with a plan with inflation indexed benefits, allows the plan to take greater risk.” What do they really mean by that? Do they mean that the plan assets will grow since it includes nominal assets which will increase with inflation? When discussing the Fed model, they also said that yield on Treasury are nominal in that they are adjusted for inflation. If this is the case, then why in schweser do they say when the liability is inflation indexed we should use real bonds and not nominal bonds? Im very confused when it gets to the relationship between inflation and real bonds and nominak bonds? I appreciate if someone can clarify this!

I got it wrong too. Here’s what I learned…

Even though plan benefits for retired lives are not indexed for inflation, the pension obligation increases for active lives because their salaries are rising with inflation. Their ultimate benefit payments will be higher, although once they retire, the benefit will be constant regardless of changes to CPI.

So, TIPS are appropriate for this plan.

View it from a liabilities’ point of view. If the benefits are not inflation-indexed, it’s good for the pension plan, which will not need to hedge the inflation. Rising inflation is a risk. Since it’s not inflation-indexed, the pension plan can take more risk in somewhere else.

Many thanks!