STRATEGIC ASSET ALLOCATION: LIABILITY RELATIVE

Learning Outcome

• recommend and justify an asset allocation based on an investor’s objectives and constraints

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The strategic asset allocation choices presented for the GPLE Corporation Pension—Recommendation A and Recommendation B—offer distinct approaches to managing pension assets in light of the pension's liabilities. Each recommendation has its pros and cons, reflecting the balance between seeking returns and managing risks relative to the pension's liabilities.

Arguments for Recommendation A (Asset-Only Approach)

Pros:

• Higher Expected Returns: By allocating a significant portion to equities (65%), this approach aims to capitalize on the higher expected returns of equities compared to fixed income. This can potentially increase the buffer between pension assets and liabilities over time.

• Growth Potential: It offers the potential for asset growth, which could further secure the pension's financial health and possibly reduce the need for future contributions by the sponsor, assuming market conditions are favorable.

Cons:

• Higher Volatility and Contribution Risk: The higher allocation to equities introduces greater volatility and risk of significant asset value decline. A 20% decline in equity values could erase the current buffer and push the pension into an underfunded status, necessitating additional contributions from GPLE.

• Mismatch with Liabilities: This approach does not consider the pension's liabilities and their characteristics (e.g., interest rate sensitivity), potentially leading to a mismatch in the asset-liability management strategy.

Arguments for Recommendation B (Liability-Relative Approach)

Pros:

• Reduced Contribution Risk: By aligning the fixed-income portfolio's interest rate sensitivity with that of the pension liabilities, this approach significantly reduces the risk of the pension becoming underfunded and requiring additional contributions.

• Stability and Predictability: It provides a more stable and predictable investment outcome, aligning with the pensioners' interest in receiving promised benefits without interruption.

• Focused on Defeating Liabilities: Directly addresses the primary objective of the pension plan—to ensure the pension liabilities are covered with minimal risk.

Cons:

• Lower Expected Returns: The heavy allocation to fixed income (90%) limits the portfolio's growth potential, leading to lower expected returns compared to an equity-focused strategy.

• Limited Upside in Favorable Market Conditions: In scenarios where equities perform well, the pension plan will not benefit as much from market upswings due to its conservative allocation.

Liability Glide Paths

For underfunded pensions like a hypothetical underfunded scenario for GPLE, a liability glide path could be an effective strategy. This approach dynamically adjusts the asset allocation based on the funded status of the plan, gradually reducing risk as the pension's financial health improves. It aims to secure the pension's funding status over time while minimizing contribution volatility, offering a structured path to achieving a stable and secure funding level.

Conclusion

The choice between Recommendation A and B for GPLE Corporation's pension plan depends on the plan sponsor's risk tolerance, the pensioners' security needs, and the overall financial objectives of the pension. While Recommendation A offers higher growth potential, it comes with increased risks, especially in adverse market conditions. Recommendation B provides a more conservative and stable approach, focusing on liability matching to ensure the pension's promises are met with minimal risk. The decision should align with a comprehensive understanding of the pension's liabilities, the market environment, and the strategic objectives of both the pension plan and the sponsoring corporation.

To illustrate the liability-relative approach, we take the defined benefit (DB) pension plan of (hypothetical) GPLE Corporation, with case facts given below.

A Frozen DB Plan, GPLE Corporation Pension

• Name: GPLE Corporation Pension

• Narrative: GPLE is a machine tool manufacturer with a market value of $2 billion. GPLE is the sponsor of a $1.25 billion legacy DB plan, which is now frozen (i.e., no new plan participants and no new benefits accruing for existing plan participants). GPLE Pension has a funded ratio (the ratio of pension assets to liabilities) of 1.15. Thus, the plan is slightly overfunded. Responsibility for the plan’s management rests with the firm’s treasury department (which also has responsibility for GPLE Corporation treasury operations).

• Tax status: Non-taxable.

• Financial assets and financial liabilities: Assets amount to $1.25 billion at market values. Given a funded ratio of 1.15, that amount implies that liabilities are valued at about $1.087 billion. Projected distributions to pension beneficiaries have a present value of $1.087 billion at market value.

GPLE does not reflect any extended assets or liabilities; thus, economic net worth is identical to traditional accounting net worth.

Exhibit 10:

GPLE Pension Economic Balance Sheet (in US$ billions) 31 December 20x6

Assets		Liabilities and Economic Net Worth
Financial Assets			Financial Liabilities
Pension assets	1.250		PV of pension liability	1.087
			Economic Net Worth
			Economic net worth	0.163
Total	1.250			1.250

GPLE, the plan sponsor, receives two asset allocation recommendations. Recommendation A does not explicitly consider GPLE’s pension’s liabilities but is instead based on an asset-only perspective: the mean–variance efficient frontier given a set of capital market assumptions. A second recommendation, “Recommendation B,” does explicitly consider liabilities, incorporating a liability-hedging portfolio based on an analysis of GPLE pension liabilities and a return-seeking portfolio.

In evaluating asset allocation choices, consider the pensioners’ and the plan sponsor’s interests. Pensioners want to receive the stream of promised benefits with as little risk, or chance of interruption, as possible. Risk increases as the funded ratio declines. When the funded ratio is 1.0, pension assets just cover pension liabilities with no safety buffer. When the funded ratio is less than 1.0, the plan sponsor generally needs to make up the deficit in pension assets by contributions to the plan. For example, with a 10-year investment time horizon and a choice between two asset allocations, the allocation with the lower expected present value of cumulative contributions to Year 10 would generally be preferred by the sponsor, all else being equal. In practice, all else is usually not equal. For example, the alternative with the lower expected present value of contributions may involve more risk to the level of contributions in adverse market conditions. For example, the 5% of worst outcomes for the present value of cumulative contributions may be more severe for the lower expected contribution alternative. Thus, possible asset allocations generally involve risk trade-offs.24 Now consider the recommendations.

Recommendation A, based on asset-only analysis, involves a 65% allocation to global equities and a 35% allocation to global fixed income. Assume that this asset allocation is mean–variance efficient and has the highest Sharpe ratio among portfolios that meet the pension’s assumed tolerance for asset return volatility. Capital market assumptions indicate that equities have a significantly higher expected return and volatility than fixed income.

Recommendation B, based on a liability-relative approach to asset allocation, involves an allocation of $1.125 billion to a fixed-income portfolio that is very closely matched in interest rate sensitivity to the present value of plan liabilities (and to any other liability factor risk exposures)—the liability hedging portfolio—and a $0.125 allocation to equities (the return-seeking portfolio). This is a proportional allocation of 10% to equities and 90% to fixed income. The equities allocation is believed to provide potential for increasing the size of the buffer between pension assets and liabilities with negligible risk to funded status. Recommendation B lies below the asset-only efficient frontier with a considerably lower expected return vis-à-vis Recommendation A.

What are the arguments for and against each of these recommendations? Recommendation A is expected, given capital market assumptions, to increase the size of the buffer between pension assets and liabilities. But the sponsor does not benefit from increases in the buffer if the current buffer is adequate.25 However, with a 0.65 × $1.25 billion = $0.8125 allocation to equities and a current buffer of assets of $1.25 billion – $1.087 billion = $0.163 billion, a decline of that amount or more in equity values (a 20% decline) would put the plan into underfunded status (assuming no commensurate changes in the liability). Thus, Recommendation A creates contribution risk for the plan sponsor without a potential upside clearly benefiting either the sponsor or beneficiaries.

For Recommendation B, because the risk characteristics of the $1.125 billion fixed-income portfolio are closely matched with those of the $1.087 billion of pension liabilities with a buffer, the plan sponsor should not face any meaningful risk of needing to make further contributions to the pension. Pensioners expect the plan to be fully funded on an ongoing basis without any reliance on the sponsor’s ability to make additional contributions. This is an excellent outcome for both. The pension liabilities are covered (defeased).

The example is highly stylized—the case facts were developed to make points cleanly—but does point to the potential value of managing risk in asset allocation explicitly in relation to liabilities. A typical use of fixed-income assets in liability-relative asset allocation should be noted: Liability-relative approaches to asset allocation tend to give fixed income a larger role than asset-only approaches in such cases as the one examined here because interest rates are a major financial market driver of both liability and bond values. Thus, bonds can be important in hedging liabilities, but equities can be relevant for liability hedging too. With richer case facts, as when liabilities accrue with inflation (not the case in the frozen DB example), equities may have a long-term role in matching the characteristics of liabilities. In underfunded plans, the potential upside of equities would often have greater value for the plan sponsor than in the fully funded case examined.

Liability Glide Paths

If GPLE were underfunded, it might consider establishing a liability glide path. A liability glide path is a technique in which the plan sponsor specifies in advance the desired proportion of liability-hedging assets and return-seeking assets and the duration of the liability hedge as funded status changes and contributions are made. The technique is particularly relevant to underfunded pensions. The idea reflects the fact that the optimal asset allocation in general is sensitive to changes in the funded status of the plan. The objective is to increase the funded status by reducing surplus risk over time. Although a higher contribution rate may be necessary to align assets with liabilities, the volatility of contributions should decrease, providing more certainty for cash flow planning purposes and decreasing risk to plan participants. Eventually, GPLE would hope to achieve and maintain a sufficiently high funded ratio so that there would be minimal risk of requiring additional contributions or transferring pension risk to an annuity provider.

The importance of such characteristics as interest rate sensitivity (duration), inflation, and credit risk in constructing a liability-hedging asset portfolio suggests the relevance of risk-factor modeling in liability-relative approaches. A risk factor approach can be extended to the return-seeking portfolio in order to minimize unintentional overlap among common factors across both portfolios—for example, credit. Exploring these topics is outside the scope of the current reading.

The next section addresses an approach to asset allocation related to liability relative in its focus on funding needs.