Study Session 5 Related

Common risk exposure is measured by the correlation between the firm’s operating characteristics and pension asset returns. The higher the correlation between firm’s operations and pension asset returns, the lower the risk tolerance. The opposite is also true. If both firm’s operations and pension asset returns are high and positive, that requires a low contribution from a company to the pension plan, and thus a company can be more aggressive on return objectives. no?

no, cuz the opposite applies. If returns on the firm and pension plan are highly correlated, then in down times forthe firm, the value of the pension plan assets also drops but liabilities remain. So at the time the firm is likely to need to increase contributions to the plan (since asset values are dropping) is the precise time they can’t afford to since profits also drop. Therefore, if pension asset returns and firm profits are highly correlated it reduces the amount of risk the plan can be exposed to.

So what happens in up times?

in up times the opposite would hold but pension allocation isn’t about making high absolute returns, its about being able to meet liabilities - avoiding an underfunded pension plan is basically requirement number one. if we could all pick up and down times that easily then your logic would hold. However, high correlation leads to a lower pension risk tolerance.