Decomposing Funding Ratio Risk: Providing Pension Funds with Key Insights into Their Liabilities Hedge Mismatch and Other Factor Exposures

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In recent years, adverse market conditions demolished the funding status of many defined benefit (DB) pension plans highlighting the need for better risk management. We propose a novel framework to decompose the risk of DB pension plans which differs from earlier work in two fundamental ways. First, while others focused on surplus risk, we give sound reasons to focus on funding ratio risk instead. Second, we include a special mismatch factor to measure the sensitivity of the funding ratio to changes in the value of liabilities. We illustrate our framework with a case study based on an actual DB pension fund and decompose its funding ratio risk into mismatch risk and other factor exposures dealing with real interest rates, inflation and economic growth risks.