Rethinking Pension Liabilities and Asset Allocation

Abstract

The objective of a defined-benefit pension fund's asset allocation policy should be to fully fund accrued pension liabilities at the lowest cost to the plan sponsor, subject to sensible risk. A major risk plan sponsors face is that higher contributions will be required should the asset portfolio not be constructed properly. Specifically, the plan sponsor in establishing its asset allocation strategy should take into account both the present value of liabilities (cash flows) and the volatile behavior of the value of the liabilities due to changes in interest rates. While fluctuations in the present value of assets versus liabilities (funding ratios) represent high financial risk for all plan sponsors, most plan sponsors fail to recognize this risk because it is seriously attenuated by actuarial and accounting smoothing of financial statements. Instead, due to the way pension contributions are calculated, and earnings reported, plan sponsors focus on the return on asset assumption rather than assets versus liabilities. The authors look at the performance of defined-benefit corporate pension plans in 2000 and 2001, and consider the implications of this performance for future corporate earnings. They then address issues associated with measuring pension liabilities and offer solutions to deal with this measurement problem.

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