Contingent Immunisation

Going through the CFAI material a questions asked whether the following was correct: “When interest rates fall, contingent immunisation switches to more active management because dollar safety margin is higher” CFAI said the statement is correct, how so?

With contingent immunization the required rate of return is less than the return that can be acheived in the market. The full portfolio will then be invested at a higher rate. If your positions move against you, there will come a time where you’ll have to duration match your assets and liabilities to ensure your target value is acheived (might all seem obvious, but getting to my point). So required return is less than the return that contingent immunization can offer you. Said another way, your portfolio has excess capital to acheive the required future value. When interest rates fall, the funds required to meet future obligations will increase, but your portfolio value (with excess capital) will increase by more… therefore dollar safety will increase and there is more scope for active management.

why does your portfolio value (i assume assets today) increase by more than what the target/required funds are?

I think it’s because your required rate of return, i.e. safety net return, doesn’t change. So, if rates go down then you should have more cushion, because your portfolio value goes up (must revalue what you’re holding, using the lower market rate) while the assets necessary to fund the required terminal value also go up, but to a lesser degree (because the numerator - required terminal value - is unchanged since the safety net return & initial asset values are unchanged). The higher the safety net return, the lower the cushion… which makes sense, because the required terminal value should be higher (i.e. need to achieve a higher RoR to hit that value). This is all very confusing, but if you work through a few sample calculations you’ll see the statement is correct.