"The liability-relative approach focuses on the liabilities themselves and entails building a portfolio designed to hedge liability exposures. Thus, the lowest risk assets to add to the portfolio are ones that are highly correlated to the pension plan liabilities. " I don’t understand the second sentence - please explain. Thanks!
In ALM approach you define risk and return objectives in terms of meeting the liabilities. So the least risky investment would be the one with the same sensitivities to relevant factors. By this way you will know that when your liabilities increase due to a certain factor, lets say interest rates, your assets will also move in the same direction and there will be no or little shortfall risk.
You can think correlation as direction of movement. In an ALM, you want your asset and liability move in the same direction to minimize surplus change. Therefore, you want high correlation.
Makes a lot more sense now - thanks
To add on to ws’s statement, “high correlation” of pension liabilities and assets equates to adding bonds (usually, or swaps) that have similar duration. Since pension liabilities are essentially PV’s of future cash flows, they have a “duration” similar to a bond (basically, the company has issued bonds to it’s employees). Therefore, to fully immunize a pension liability, the company would invest in a ladder of bonds with coupon/maturity payments sufficient to payoff future benefit payments (one way to do it).
Another way to think about it is if you have a portfolio that consists of both your assets (whose exposures and weightings you control) and your liabilities (which usually don’t control but which you need to understand), and then you are managing to maintain a surplus, or at least not a deficit. Mathematically, this is more complex, but conceptually, it clarifies things a bit. Your portfolio can be thought of as being a short position in your liabilities, and then long positions (and shorts, if the IPS allows) in your assets. You then lower your risks by having assets that are negatively correlated with the short liabilities positions, but since a short position has the opposite correlation sign as a long position, it means that you are actually looking for assets that are highly positively correlated to the liability values. This is why it is a bit counterintuitive, because usually you are looking for negative correlation, but in this case, the fact that your liabilities are essentially shorts, means that you are looking for high positive correlations.