Immunization of Pension Funds and Sensitivity to Actuarial Assumptions

Abstract

Changes in rates of return affect both the assets and liabilities of a pension fund. If these assets and liabilities are in a proper relationship with each other, however, the pension fund can be irnmunized from the change in rates of return. The cornerstone of the immunization strategy is management of the duration, or weighted average life, of the asset portfolio. This paper discusses some of the factors to be considered in immunizing a medium-sized pension fund, including whether immunization is in fact a desirable strategy. A pension fund is subject to risks on both the asset and liability sides of its balance sheet. Risks on the liability side relate to the probability that the amount of pension benefits actually payable (ex post) will differ from the amounts expected to be payable (ex ante) based on actuarial calculations. Initial assumptions about employee turnover rates, mortality rates, or salary scales may turn out to be incorrect. Risks on the asset side relate to the probability that assets available for making pension payments as they become due (ex post) will differ from the amounts expected to be available (ex ante). Initial assumptions about the rate of return to be earned on pension fund investments may turn out to be wrong (due either to superior or poor investment decisions by the fund administrator or to unexpected changes in marketwide rates of return). Also, the assumed level of operating costs (such as for actuarial, legal, developmental, financial, or administrative services) may turn out to be incorrect. These risks are not entirely independent, nor are they of equal importance. Some of the risks, such as unexpected changes in operating costs, are subject at least partially to the control of the fund administrator. Others, such as changes in rates of affecting all investments, are related to Richard J. Keintz, Ph.D. and CPA, was the Deputy Commissioner of Insurance, State of Wisconsin, when the article was written. Currently he is Vice President-Director of Research, the CUNA Mutual Insurance Society, Inc., in Madison, Wisconsin. He was associated with Touche Ross and Company and later served on the faculty of the University of North Carolina at Chapel Hill. Clyde P. Stickney, DBA and CPA, is an Associate Professor of Accounting, Amos Tuck School of Business Administration, Dartmouth College. He has served oIn the faculties of the University of Chicago and the University of North Carolina at Chapel Hill. The authors acknowledge the helpful and thought-provoking comments of Roman L. Weil and two anonymous reviewers. 1 The term market rate of return' is used instead of interest rate to reflect the fact that pension funds invest in several types of investments (common and preferred stock, real estate, and fixed dollar commitments) and not just fixed dollar commitments.