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16-linking-pension-liabilities-to-assets.html
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<!doctype html>
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<title>Study Session 5 | Reading 16 | Linking Pension Liabilities to Assets</title>
<meta name="description" content="Chartered Financial Analyst Level 3 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<section>
<h1>Reading 16</h1>
<h3>Linking Pension Liabilities to Assets</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">AlchemistsAcademy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Introduction</h2>
<img src="images/16/asset-only-and-liability-relative-perspectives.png" alt="asset-only and liability-relative perspectives" />
<ul>
<li>Risk exposures include both the short-term volatility of plan costs and the long-term risk of pension assets being insufficient to defease liabilities</li>
</ul>
<aside class="notes">
Selecting portfolios from an asset-only perspective implicitly assumes that the liability has no market-related risk at all. However, in truth, pension liabilities are driven by economics and have many market related exposures.
</aside>
</section>
<section>
<h2>Decomposing Pension Liabilities</h2>
<ul>
<li>Liabilities can be valued similar to assets:</li>
<ol>
<li>Project estimated benefit payments</li>
<li>Discount them at the appropriate discount rate</li>
</ol>
<li>Market related exposures:</li>
<ul>
<li>Inactive participants</li>
<li>Active participants</li>
<li>Future participants</li>
</ul>
<li>Non-market related exposures: liability noise</li>
<ul>
<li>Inactive participants</li>
<li>Active participants</li>
</ul>
</ul>
<aside class="notes">
The market related exposures of pension liabilities include: (1) the benefits attributable to participants currently receiving pension payments (retirees), or participants who no longer work for the firm but have yet to start receiving benefits; (2) the estimated benefit payments associated with active employees. This can be broken down into two compenents: accrued benefits from past services rendered and benefits attributable to future services (future wages, future wage inflation, future real wage growth, and future services rendered); and (3) the esimated benefit payments associated with future new employees. Non-market exposures include: (1) mortality risk of inactive participants (i.e. they might live longer than expected) and (2) the uncertainty of assumptions regarding the withdrawal, disability, and retirement of active participants.
</aside>
</section>
<section>
<h2>Designing Investment Policies Relative to Liabilities</h2>
<p>Investment challenge is to efficiently allocate assets to high risk/return asset classes while minimizing the amount of unrewarded risk assumed versus the liability</p>
<ol>
<li>Hedge the liability using derivatives</li>
<li>Allocate the remaining capital to efficient return generation within the asset-only space
</ol>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
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