Can anyone do a quick synopsis of what to know for Liability Relative Approach?

It looks like there are a few key points that can sum up the main message CFAI wants to get across.

I remember something about stocks…bonds…and derivatives vs no derivatives for asset only? Something about inflation growth in wages should be nominal, growth in gdp should be real bonds (TIPS?), and salary growth equity?


3 moving pieces

  1. inactive participants -> Retireds + deferreds - benefit payments are fixed in a market related sense unless indexed to inflation.

  2. no inflation adjustment -> fixed in nominal terms - nominal bonds

  3. with inflation adjustment -> needs both nominal bonds + real bonds

  4. active employees

2 parts to the benefits

  1. benefits attributable to past service rendered and wages earned = accrued benefits.
  2. benefits attributable to future service (future benefits).

accrued benefits - susceptible to term structure changes = changes in discount rate, inflation, nominal bond premium. So “nominal bonds” = liability mimicking portfolio.

future benefits due to future wages = exposed to inflation, growth and term structure. so nominal bonds, real rate bonds, equities.

  1. Future participants
  • if plan is closed to future participants = this would be 0.
  • for an ongoing plan this is rarely funded.
  • most uncertain of all benefits discussed thus far

non market related exposures = liability noise

  1. due to plan demographics being different from actuary model since underlying probabilities are certain.

the main factor driving this is number of participants. if the # of participants is large this will closely track the actuary’s model.

  1. model uncertainty -> underlying probabilities are not certain (mortality change due to medical innovations).

Asset only perspective -> 60-70% equities + remainder to short and intermediate duration nominal bonds.

liability relative -> longer duration nominal bonds + real bonds + equities + derivatives to hedge the liability and remainder in a return focused well diversified component.

— why may corps not implement the liability mimicking portfolio

  1. investing in the liability mimicking portfolio will not generate returns in excess of the liability.
  2. future service benefits and future participant benefits would be defeased therefore by future cash contributions
  3. this is a low risk strategy - but is too expensive to maintain in the long run. so this is normally used as a benchmark to measure investment risk, rather than invest in it.

Impressive response, cpk.

When a problem says the plan is inflation indexed vs not inflation indexed, it seems to imply no real rate bonds - is this correct?

You still need equity for the active future wage inflation, but no real rate since it says not inflation indexed?