In Search of the Liability Asset

Abstract

When one looks beyond the immediate pension plan liabilities represented by existing obligations, one sees a stream of long-term obligations that will shift as underlying economic factors such as inflation and productivity change. Thus the pension liability may be broken down into a short-term, bond-like component and a long-term, equity-like component. Plan investments need to meet the immediate obligations and avoid deterioration of the current asset/liability ratio, but they also need to maximize long-term returns in order to meet the long-term obligations.An all-equity portfolio meets the latter need, but is far too risky in the short term. A fully hedged, dedicated portfolio will ensure that short-term obligations are met, but will do little to increase asset value to meet the incremental, long-term obligations. The task confronting the pension plan sponsor is to construct the liability asset—the asset that will meet these disparate aspects of the pension liability.Doing so requires a dynamically adj...