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 have demolished the funding status of many defined benefit (DB) pension plans, highlighting the need for better risk management. In this article, the authors 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, the authors give sound reasons to focus on funding-ratio risk instead. Second, the authors include a special mismatch factor to measure the sensitivity of the funding ratio to changes in the value of liabilities. They illustrate their 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.