The following excerpt is from a January 18, 2008 article ("LDI Strategy that is Liable to Word?") by Penny Green, Chief Executive of the SAUL Trustee Company (a U.K

Question

that advises on pension management) and deals with liability-driven strategies:
"…there is no one asset class that precisely matches a plan's liabilities. It is the case that bonds provide a cash flow that can be used to meet the cash flows out of a pension plan. But so do equities – it is just that the cash flows from equities (dividends) cannot be guaranteed. However, bonds do not cover longevity risk or salary inflation, so bonds are not a perfect match – but neither do equities. In fact, there is no asset class at present that matches longevity risk or salary inflation. This is the trustee's dilemma that LDI strategies are supposed to resolve."
Explain why you agree or disagree with this viewpoint.

Answer 1

In general one would agree with the views being presented concerning (i) the problems of any asset class rendering cash flows that can perfectly match a plan's liabilities, and (ii) the shortcomings of any asset class meeting longevity risk. More details are given below.

While the general points made are valid, one might disagree a bit with the perspective that equities (like bonds) can provide a cash flow to meet the cash flows needs of a pension fund. First, dividend streams for most equity investments are less than cash flows streams from fixed investments. An exception might be preferred equity but even here their dividend streams might be less than most bonds. Second, cash flow streams produced from selling equity are not guaranteed as equity prices are volatile and can fall sharply in a short period of time and in an untimely fashion to meet pension fund liabilities. Absent the use of derivatives to hedge prices, when stocks perform poorly for a long period of time, they lose their capacity to be an inflation hedge.

In the same article from which the previous quote was made, the author states:
"From the mid-1950s to the late 1990s, conventional wisdom was that equities were the closest match to a pension plan's liabilities. Thus, whenever an asset liability exercise was performed (the aim of which was to find an investment strategy that matched the liabilities of the plan), the result was a recommendation that the assets of a plan should be weighted to equities. In the late 1990s, this orthodoxy was turned on its head and bonds became the asset class assumed to be most closely matched to the liabilities. Combine this with a fall in the equity markets, and high bond prices (and low yields), and it is easy to see how surpluses in the 1990s turned into deficits in the early part of this century. And in response to the changing theory, the results from the asset liability models changed."
This statement drives home the point that no one asset type is reliable over time, thus pointing out the fact that liability-driven strategies (applied to defined pension plans) must deal with two risks that may not be handled adequately by investing in the major asset classes. First, one risk (that must be dealt with when investing in asset classes) is the impact of inflation on future pension liabilities. An increase in the inflation rate increases future liabilities as salaries are adjusted upwards. At one time the view was that equities were the suitable asset class for dealing with inflation. As pointed out in the above statement, because of the volatility in equity prices, adverse movements in equity values may not mitigate inflation risk. Second, another risk (that must be dealt with when investing in asset classes) is longevity risk. This is the risk that beneficiaries may live longer and as a result future liabilities will exceed current actuarial determined liabilities.