what characteristics of pensions govern the usage of nominal or real bonds?
active lives to retired lives ratio
age of employees
pension benefit infation-related features
Accrued Benefits :
Depends on whether the fund offers inflation indexation : If yes , then real bonds else nominal bonds
Future benefits: ( 3 components )
a)Future Wages , b) Future Service , c) New Entrants.
a)Future Wages : Divided into:
i) Future Wage Inflation and ii) Future Real Wage Growth
Future Wage Inflation usually grows with general inflation , so best mimiced by Real Rate bonds , but usually Wage inflation exposure stops at Retirement ,after which nominal bonds would better mimic this portion of the liablity. So we’re left with a combination of real-and-nominal.
Future Real Wage growth : Since there is very strong evidence in terms of correlation between real wages and GDP growth , so equities best represent an asset that would mimic the growth . However again the liability growth stops with retirement so a combination of equities and nominal bonds should serve as the benchmark.
b) Future Service benefits: ( these are the fallout effects of wage growth and wage inflation because many benefits are indexed to the wages workers receive . Some example are 401K matching benefits where benefits are proportionate to wages ). These are often not modeled in the liability i.e. benchmark side because of various uncertainties in the assumptions , So they are excluded.
c) Future entrants : For closed funds this portion is zero. Even for growing plans this portion is ignored and certaily not funded , and the reason is that it is usually impossible to predict over the long term. So the benchmarks used normally ignore this part.
TABLE 2 Market Related Exposures and Liability Mimicking Assets** Investment Benchmark **** Market Related Exposures Liability Mimicking Assets** Inactive Term structure Nominal bonds Active—accrued Term structure Nominal bonds Active—future wage Inflation Real rate bonds Growth Equities Term structure Nominal bonds page 492 in book 2 of CFAI text
thank you jana for such a detailed explaination.
silly question- if benefits are inflation indexed and we still use nominal bonds, wouldn’t that provide extra return ?
they would if they were equities lol…
I have confusion between 2010 AM Q3 B (CarbX) and regarding CFAI material on Page 490 Vol 2
As per CFAI, for frozen plans -->future benefit =0 -->Only acrrued benefit liability --> Use nominal+index-linked bonds
However, in 2010 AM Q3 B (CarbX) , Trade E is selecting resulting in 0% allocation to real rate bonds.
Could sombody provide explanation ?