Q3A, p.372, Reading 21, CFAI Book 2 (under the reading for Institutional WM) I understand the reason for decrease in plan surplus being that “PV of pension liabilities are rising faster than the market value of the assets” However, I don’t understand why the liabilities are rising at only 12% (the so-called price gain element of the corresponding 10-year duration bond) — instead of the total return of 19%. Could somebody shed light on that? - sticky
I don’t have the question in front of me (will double check tonight), but I think it could happen like this: For a bond, the total return is the coupon + price increase (=19%) For a pension liability, the liability will grow with the price increase portion, but the “coupon” payment doesn’t increase the pension liability, since the benefit payments paid during the period are gone and are not added to the pension liability after they are pad out. For example: Liability(t) = PV cash flows (t,t+1,t+2 etc…) Liability(t+1) = PV cash flows(t+1,t+2 etc…) not sure if I answered your question…
For this question it also has to do with the fact that the total return on the assets was only 10%, whereas pension liabilities increased by the 12% capital gain we noted for U.S. long term bonds.
strikershank Wrote: ------------------------------------------------------- > For this question it also has to do with the fact > that the total return on the assets was only 10%, > whereas pension liabilities increased by the 12% > capital gain we noted for U.S. long term bonds. this is where I am confused. Why 12%, not 19% with the 10-year duration bond? - sticky
Think of it that only 12% portion of 19% return had to do with decrease in interest rates (7% came from coupons and is irrelevant for as far as pension liabilities are concerned). The decrease in interest rates caused price appreciation of bonds and increased PV of the pension liabilities by 12%, whereas total return on plan assets was only 10%, hence the surplus will decline.