CHAPTER 27

LIABILITY-DRIVEN INVESTING
FOR DEFINED BENEFIT PENSIONS PLANS

CHAPTER SUMMARY
This chapter focuses on liability-driven investing for defined benefit pension plans. The chapter
begins with a description of how historically pension plan sponsors incorrectly formulated
investment policy by focusing solely on the asset side. After covering measures used to describe
the health of a defined benefit pension plan, liability-driven investing strategies are described that
take into account their liability obligations.

HISTORICAL BACKGROUND

Historically, defined benefit (DB) pension plans were predominately managed only with the assets
in mind. The assumption that sponsors made was that if assets grew as indicated by the major
market indexes for the different asset classes, they would somehow in the long run be sufficient to
satisfy obligations.

Since the passage of the Pension Protection Act of 2006, sponsors of DB pension plans must now
mark to market their projected liabilities based on prescribed discount rates that were phased in in
2012. Even prior to the decline of interest rates to the current low rates, research reported that DB
pension plan sponsors were reluctant to embrace liability-driven investing (LDI). Regulations
adopted in the United States as set forth in the Pension Protection Act of 2006 have changed for
DB pension plans.

UNDERSTANDING THE LIABILITIES OF A DB PENSION PLAN

To effectively manage liability risks, we begin examining how a DB pension plans future
liabilities are projected over the lifespan of the members and then we value the projected future
liabilities.

The terms of the DB pension plan set forth the vesting requirements and the amount to be paid to
members upon retirement at different ages. Forecasting of liabilities requires making assumptions
about the rate of inflation and the expected life of the members.

The appropriate discount rate(s) involving the valuation of projected liabilities has been
extensively debated. Most agree that the term structure of interest rates should be used over a single
interest rate. The strongest argument is for discounting using Treasury spot rate curve based on the
rates offered on Treasury strips. However, that is not the view of regulators. The Pension Protection
Act requires that companies discount pension liabilities using corporate bond yields with at least
an A rating. Because Treasury rates are lower than corporate rates, using corporate rates results in
a lower value for the liabilities.

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Three arguments have made in favor of Treasury rates and against high-quality corporate bond
rates. First, the liabilities can be viewed as riskless cash flows that must be paid by the sponsor of
the DB pension plan. Second, if the ultimate purpose is to eliminate the interest-rate risk
component of the liabilities, then it is not possible for a large number of DB pension plans to create
a hedging portfolio of corporate bonds with at least an A rating. Third, corporate bond rates offer
a spread over Treasury rates to compensate for credit risk and liquidity risk. The result of the 50
bps increase in the credit spread results in an improvement in the financial health of a DB pension
plan causing a DB pension plan to be better off. Despite arguments against the use of corporate
bond rates to discount liabilities, the Pension Protection Act of 2006 allows these rates.

Risks Associated with Liabilities

There are three risks associated with a DB pension funds projected liabilities: interest-rate risk,
inflation risk and longevity risk.

The interest-rate risk for the projected liabilities can be quantified in the same way as for assets:
computing the duration for the liabilities. We refer to this duration as liability duration. Given
the long-term nature of the liabilities, the significance of a liability duration is important in the
formulation of an LDI strategy because hedging interest-rate risk involves dollar-duration
matching of assets and liabilities.

Inflation risk for a DB pension plan is the risk that the actual rate of inflation experienced over
the projection period will be greater than that assumed in projecting liabilities.

Longevity risk for a DB pension plan is the risk that actual life expectancy of plan members
beyond their retirement date will exceed the life expectancy assumed in projecting the liabilities.
As a result, the amount that will actually have to be paid to the plan member will exceed the amount
projected.

Funding Gap, Funding Ratio, and Sponsor Contributions

The funding gap is the difference between the market value of the assets and the value of the
liabilities. That is,

Funding gap = Projected value of the liabilities Market value of fund assets

The funding gap is also referred to as an unfunded liability.

Funding gap risk is the dollar amount by which the funding gap will increase due to adverse
changes in the factors that impact the assets and liabilities, which include the following risks:
interest-rate, inflation, longevity, credit, liquidity, currency and call/prepayment risks. The
volatility of the funding gap depends on the volatility of these risk factors. The concern with the
volatility of the funding gap is that regulatory funding requirements may require additional
contributions by the DB pension plan sponsor.

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An alternative way of looking at the health of a DB pension plan is to look at the plans assets as
a percentage of its projected liabilities. The ratio is called the funding ratio:

Market value of fund assets

Funding ratio =
Projected value of the liabilities

The lower the funding ratio, the greater the funding gap.

Besides the underfunding of the DB pension plan at the time of inception, the funding gap arises
primarily because the asset allocation decision that the plan sponsor chose in the past resulted in
poor performance relative to the value of the liabilities. In making the asset allocation decision,
plan sponsors historically considered the relative performance of asset classes to each other
without a thought given to liabilities. It is the eventual recognition of the need to design investment
strategies taking into account liabilities that has recently led to the greater use of LDI.

A funding gap does not have to be closed in a single year. In addition to performance in terms of
the funding gap/funding ratio, there are annual contributions that a plan sponsor may have to make.
The annual contribution, called the annual required contribution, is determined by an actuary and
consists of two components. One component is the estimated cost of new benefits earned by
members during the year. This cost is referred to as the normal cost. Added to the normal cost is
an additional amount that is based on the funding gap. In designing an LDI strategy, an objective
sought by DB pension plan sponsors is to minimize annual contributions.

LDI STRATEGIES

Understanding the nature of the risks on both the asset and liability sides of the funding gap can
assist in formulating LDI solutions.

All-High-Grade-Bond Portfolio Solution

One solution to a funding gap problem is to create a portfolio comprised of only high-grade bonds
and interest-rate derivatives. To understand what is done, ignore all risks other than interest-rate
risk. A first approximation for the funding gaps exposure to interest-rate risk is the dollar duration
of the assets and liabilities. That is,

Funding gap interest-rate risk = Change in the funding gap due to interest-rate risk =
Dollar duration of projected liabilities Dollar duration of fund assets

As interest rates change, the relative change in the market value of the assets and liabilities will
change depending on their respective dollar duration. If the dollar duration of the projected
liabilities exceeds that of the dollar duration of the funds assets, then a rise in interest will reduce
the funding gap as the liabilities will decline by more than the assets.

To hedge or immunize (at least as a first approximation) against interest-rate risk resulting in
adverse change in the funding gap using a bond-only portfolio, the funds portfolio can be

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constructed and rebalanced so as to maintain the dollar-duration match to prevent the funding gap
from increasing.

If we let the market value of fund assets be $500 million, the liability dollar duration be $72 and
(Dp) denote duration for the portfolio, then for a 100-bp change in interest rates the portfolio dollar
duration is
0.01 Dp $500 million
This amount must be equal to the dollar duration of the liabilities of $72 million. That is,
0.01 Dp $500 million = $72 million
Solving, we find Dp is equal to 12 so that the portfolio duration is the same as the liability duration.
This avoids a change in the funding gap as a result of a rise in interest rates.

The above illustration has two problems. First, it is difficult to obtain the necessary dollar duration
to hedge interest-rate risk. In our illustration, a duration of 12 is not likely to be accomplished with
high-grade bonds. The solution is to use interest-rate derivatives such as futures and swaps to
extend dollar duration. Second, the matching of duration provides a hedge against interest-rate
risk for a small change in interest rates. If interest rates move substantially between portfolio
rebalancing periods, the convexity of the assets and liabilities must be matched as closely as
possible.

Besides interest-rate risk, there are still other risks. For example, there is concern with adverse
movements in credit spread risk and liquidity risk. For high-grade callable bonds, there is call risk.
For portfolios with agency residential mortgage-backed securities, there is prepayment risk. The
exposure to the other risks depends on the plan sponsors risk tolerance, which, in turn, depends
on the DB pension plan sponsors ability to meet annual required contributions if the strategy
results in an increase in the funding gap.

LDI Strategy Beyond High-Grade Bonds and Derivatives

Because of the disadvantages of an LDI strategy that hedges only interest-rate risk when bonds
and derivatives are used, a strategy that involves a greater range of asset classes to control the level
of interest-rate, inflation, and longevity risk has been used in practice. Asset classes are selected
that are highly correlated with these risks such that an adverse movement in any of the risks that
adversely impacts the funding gap on the liability side will be offset (in whole or in part) by a
favorable impact on the assets. Inflation risk can be controlled by the use of inflation-protection
fixed-income instruments such as TIPS.

A portfolio created for the purpose of generating asset growth is referred to as the performance-
seeking portfolio or the excess return portfolio. The total plan return can then be viewed as

Total plan return = Return on liability-immunizing portfolio +

Return on performance-seeking portfolio Return on liabilities

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One can think of the strategy to manage risks as a beta strategy (where the benchmark is the
liabilities) and that of generating asset growth as an alpha strategy.

Introducing cash market instruments that offer a greater risk premium than that offered by
high-grade bonds results in exposure to other investment risks. Once again, the level of
exposure that a plan sponsor is willing to accept depends on its risk tolerance, which, in turn,
depends on the plan sponsors ability to meet any additional contributions in excess of normal
cost.

Because the strategy for generating asset growth involves investment strategies for equities and
alternative investments, we will not discuss this strategy here.

DE-RISKING SOLUTIONS TO MITIGATE RISK

Three solutions have been used by sponsors of DB pension plans to mitigate the risks that they
face. These solutions, referred to as de-risking solutions, are: closing (freezing), termination and
risk transference. Basically, these solutions are a means for dealing with longevity risk.

Closing a fund plan means freezing the plan, not terminating it. The plan remains insured by the
federal insurer, the Pension Guaranty Benefit Corporation (PGBC). There are three types of plan
freezes. Hard freeze is where all employees may not earn any further benefits under the plan but
employees become immediately vested in what they have earned. Partial freeze is where the
benefits may not increase for some employees. Soft freeze is where employees are no longer
allowed to obtain pension credit for future years of work. A frozen plan can be unfrozen at the
election of the employer.

The termination of a plan results in the plan operations stopping completely and cannot be
unterminated. For an underfunded pension plan, the assets are turned over to the PBGC. That
federal insurer will then make the promised payments to the plan members. If the plan is
overfunded, the plan assets will be transferred to a qualified insurer that will then be responsible
for making the full benefit payments to the plan members.

Pension sponsors can buy out the vested employees with a lump-sum payment transferring pension
risk to the members. Other risk transference solutions include buy-outs, buy-ins, and longevity
swaps. In a buy-out, the sponsor transfers the pension risk from the plan sponsor to the issuer of
an annuity. This solution is referred to as annuitization. With a buy-in, there is only a partial
transference of the pension risk. The hedging of longevity risk can be obtained by the pension plan
entering into a longevity swap or a longevity bond.

STRATEGIES FOR HEDGING INTEREST-RATE RISK

The single-period immunization strategy is not a strategy used by DB pension plans to hedge
interest-rate risk because it involves hedging only a single liability payment in the future. The
strategy is used by life insurance companies to hedge the interest-rate risk of a popular insurance
product: a guaranteed interest contract (GIC).

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Single-Period Immunization

Immunization is the investment of the assets so that it is immune to a general change in the rate of
interest. To comprehend the basic principles underlying the immunization of a portfolio against
interest-rate changes so as to satisfy a single future liability, consider the situation faced by a life
insurance company that sells a GIC. If the GIC has a maturity of H years with a guaranteed rate of
r and the amount invested is I, then the amount that the insurer is agreeing to pay at the end of H
years (i.e., the guaranteed value), denoted by F, is

F = I(1 + r)H

The three sources of return needed to generate sufficient funds to realize the guaranteed value are
the coupon interest, interest-on-interest and capital gains. The principle in immunization theory is
that although the coupon interest is not impacted by a change in interest rates, the last two sources
are. Moreover, they have offsetting effects. Reddington showed the conditions for this offsetting
to occur when constructing and rebalancing a portfolio.

Immunization Risk

The two conditions for the immunization of a single liability mean that a portfolio will be
immunized against interest-rate changes only if the yield curve is flat and any changes in the yield
curve are parallel changes (i.e., interest rates move either up or down by the same number of basis
points for all maturities).

Immunization risk is the risk of reinvestment. The portfolio that has the least reinvestment risk
will have the least immunization risk. When there is a high dispersion of cash flows around the
liability due date, the portfolio is exposed to high reinvestment risk. When the cash flows are
concentrated around the liability due date, as in the case of the bullet portfolio, the portfolio is
subject to low reinvestment risk.

Researchers have developed a measure of immunization risk. They have demonstrated that if the
yield curve shifts in any arbitrary way, the relative change in the portfolio value will depend on
the product of two terms. The first term depends solely on the characteristics of the investment
portfolio. The second term is a function of interest-rate movement only. The first term, then, is a
measure of risk for immunized portfolios, denoted by M 2, and is equal to
CF 1 H CF 2 H CFn n H
2 2 2
M 1
2
2 . . .
1 y 1 y
2
1 y
n

where CFt = cash flow of the portfolio at time period t, H = length (in years) of the investment
horizon or liability due date, y = portfolio yield, and n = time to receipt of the last cash flow.

The objective in constructing an immunized portfolio, then, is to match the portfolio duration to
the liability duration and select the portfolio that minimizes the immunization risk M 2. The
immunization risk measure can be used to construct approximate confidence intervals for the
guaranteed value.

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Zero-Coupon Bonds and Immunization

One approach to immunizing a portfolio against changes in the interest rates so as to eliminate
immunization risk is to invest in zero-coupon bonds with a maturity equal to the investment
horizon. This is consistent with the basic principle of immunization because the duration of a zero-
coupon bond is equal to the liability duration.

Credit Risk and the Guaranteed Value

The guaranteed value may not be achieved if any of the bonds in the portfolio default or decrease
in value because of credit quality deterioration. Restricting the universe of bonds that may be used
in constructing an immunized portfolio to Treasury securities eliminates credit risk.

Call Risk

When the universe of acceptable issues includes corporate bonds, the realization of the guaranteed
value may be jeopardized if a callable issue is included that is subsequently called. Call risk can
be avoided by restricting the universe of acceptable bonds to non-callable bonds and deep-discount
callable bonds.

Constructing the Immunized Portfolio

When the universe of acceptable issues is established and any constraints are imposed, the portfolio
manager has a large number of possible securities from which to construct an initial immunized
portfolio and from which to select to rebalance an immunized portfolio.

Multi-Period Immunization

For DB pension plans, there are multiple liabilities that must be satisfied. Two strategies can be
used to satisfy a liability stream: multi-period immunization, and cash flow matching. Multi-period
immunization is a portfolio strategy in which a portfolio is created that will be capable of satisfying
more than one predetermined future liability regardless of whether interest rates change. In the
special case of a parallel shift of the yield curve, researchers demonstrate the necessary and
sufficient conditions that must be satisfied to assure the immunization of multiple liabilities.

Cash Flow Matching

An alternative to multi-period immunization is cash flow matching that can be summarized as

follows. A bond is selected with a maturity that matches the last liability stream. An amount of
principal plus final coupon equal to the amount of the last liability stream is then invested in this
bond. The remaining elements of the liability stream are then reduced by the coupon payments on
this bond, and another bond is chosen for the new, reduced amount of the next-to-last liability.
Going backward in time, this cash flow matching process is continued until all liabilities have been
matched by the payment of the securities in the portfolio.

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The differences between the cash flow matching and multi-period immunization strategies should
be understood. First, unlike the immunization approach, the cash flow matching approach has no
duration requirements. Second, with immunization, rebalancing is required even if interest rates
do not change.

Symmetric cash matching allows for the short-term borrowing of funds to satisfy a liability prior
to the liability due date. The opportunity to borrow short term so that symmetric cash matching
can be employed results in a reduction in the cost of funding a liability.

A popular variation of multi-period immunization and cash flow matching to fund liabilities is one
that combines the two strategies. This strategy, referred to as combination matching or horizon
matching, creates a portfolio that is duration matched with the added constraint that it be cash
matched in the first few years, usually five years. The advantage of combination matching over
multi-period immunization is that liquidity needs are provided for in the initial cash flow matched
period.

KEY POINTS

Liability-driven investing (LDI) involves controlling investment risk with the objective of
satisfying a clients liability rather than trying to outperform an asset benchmark or a peer
group.
LDI is concerned with the investment risk associated with assets and liabilities.
Defined benefit (DB) pension plan sponsors are using LDI solutions in the management of
their plans in contrast to what they have done in the past, which was to manage assets only
against asset benchmarks with no or little regard for the liabilities.
As a result of the Pension Protection Act of 2006, liabilities are valued by discounting the
projected liabilities using a term structure of interest rates based on corporate bonds with
at least an A rating.
The value of a pension liabilities changes inversely with the change in interest rates.
In projecting the pension liabilities, assumptions are made about the inflation rate and the
life expectancy of members of the plan.
The health of a DB pension plan is measured by its funding gap (i.e., the difference between
the value of the projected liabilities and the market value of plan assets) and the funding
ratio (i.e., the ratio of the market value of fund assets to the value of the projected
liabilities).
Funding gap risk (funding ratio risk) is the risk that the funding gap will increase (funding
ratio will decrease).
Funding gap (funding ratio) risk is the risk associated with adverse movements that impact
assets and liabilities.
The risks associated with the liabilities are interest-rate risk, inflation risk, and longevity
risk.
For a DB pension plan, longevity risk arises because the actual life expectancy of plan
members may exceed the life expectancy assumed in projecting the liabilities, resulting in
a greater number of years for which pension contributions are made.
One LDI solution to the problem faced by DB pension plans is to remove the interest-rate
risk by using bonds and interest-rate derivatives.

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 Because the hedging of interest-rate risk requires the matching of portfolio duration and
liability duration, a portfolio must be constructed with assets that can produce a duration
that is the same as the liability duration. Given the long liability duration of the typical DB
pension plan relative to the duration of bond durations during most interest-rate periods,
interest-rate derivatives are needed to extend the portfolio duration.
Two LDI solutions that have been proposed are (1) using only high-grade bonds and
interest-rate derivatives to hedge interest-rate risk and (2) using all available asset classes
to construct two portfoliosa portfolio for hedging interest-rate risk and a performance-
seeking portfolio to close the funding gap.
De-risking solutions that have been used by sponsors of DB pension plans are (1) closing
(freezing) a plan, (2) terminating a plan, and (3) transferring risk.
Strategies to hedge interest-rate risk include multi-period immunization and cash flow
matching.
Immunization theory is an interest-rate hedging strategy designed so that as interest rates
change, interest-rate risk and reinvestment risk will offset each other in such a way that the
minimum accumulated value is the guaranteed value.
An immunization strategy requires that a portfolio manager create a bond portfolio with a
duration that is equal to the liability duration.
Because immunization theory is based on parallel shifts in the yield curve, the risk is that
a portfolio will not be immunized even if the duration-matching condition is satisfied.
Immunization risk can be quantified so that a portfolio that minimizes this risk can be
constructed.
Multi-period immunization is a duration-matching strategy that exposes the portfolio to
immunization risk.
A cash flow matching strategy does not impose any duration requirement.

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 ANSWERS TO QUESTIONS FOR CHAPTER 27
(Questions are in bold print followed by answers.)

1. How does a defined benefit pension plan differ from a defined contribution plan?

A defined benefit (DB) pension plan is one of two types of pension plans provided by plan sponsors
such as corporations and government entities for their employees. The other type is a defined
contribution (DC) pension plan. DB pension plans differ from DC pension plans in that the
retirement benefits of the former are the liabilities of the sponsor.

2. Why in managing a defined benefit pension plan is it necessary for the plan sponsor to
pursue a liability-driven solution rather pursue a strategy that focuses only on management
of the assets?

The passage of the Pension Protection Act of 2006 makes it imperative for the plan sponsor to
pursue a liability-driven solution rather than pursue a strategy that focuses only on management of
the asset. In particular, this act states that sponsors of DB pension plans must now mark to market
their projected liabilities based on prescribed discount rates that were phased in in 2012.

3. You overheard a conversation by trustees of a defined benefit pension plan about how
successful they have been in making asset allocation decisions and selecting asset managers.
Every year their asset allocation decision has resulted in the allocation to the top-performing
asset classes, and the managers that they selected outperformed the asset class benchmark.
Comment on whether or not you can judge whether these trustees did an effective job in
directing the pension plan.

It is hard to judge whether these trustees did an effective job in directing the pension plan without
knowing to what extent the value of the liabilities have changed. What the trustees should primarily
consider is the funding gap, which is the difference between the market value of the assets and the
value of the liabilities. Thus, knowing an increase in assets is not enough but what is important is
how their increase compares with changes in the liabilities. For example, if the increase in
liabilities is greater than that of assets, then the trustees cannot claim to have done an effective job
in directing the pension plan.

4. Why is the projected value of the liabilities of a defined benefit plan dependent on the
discount rate used in the valuation process?

The value of any series of cash flows are greatly influenced by the discount rates used. Lower
discount rates representing less risky forms of borrowing will enable the present value of cash
flows to be greater compared with higher discount rates. The value of cash flows associated with
liabilities is highly sensitive to the discount rates used due to the long-term nature of the liabilities.
More details are given below.

For defined benefit plans, the appropriate discount rate or discount rates at which the projected
liabilities should be discounted has been an extensively debated topic. The first issue is whether

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it should be a single discount rate or a term structure of discount rates. Most would agree that
the term structure of interest rates should be used. The real controversy is over which term
structure from the bond sector to use. The strongest argument is for discounting using the term
structure of Treasury rates. In fact, to be more specific, it is the Treasury spot rate curve that
should be used based on the rates offered on Treasury strips. However, that is not the view of
regulators. The Pension Protection Act requires that companies discount pension liabilities using
corporate bond yields with at least an A rating (AAA, AA, or A). Because Treasury rates are
lower than corporate rates, using corporate rates results in a lower value for the liabilities.

Three arguments have made in favor of Treasury rates and against high-quality corporate bond
rates. First, the liabilities can be viewed as riskless cash flows that must be paid by the sponsor
of the DB pension plan. Consequently, the liabilities should be discounted at default-free rates.
Although Treasuries are not default free, they are the financial instrument that market
participants view as having the least default risk. Second, if the ultimate purpose is to eliminate
the interest-rate risk component of the liabilities, as explained later, then it is not possible for a
large number of DB pension plans to create a hedging portfolio of corporate bonds with at least
an A rating. That is, there is not a large enough supply of corporate bonds rated at least A for
DB pension plan sponsors to eliminate interest-rate risk. Finally, what is odd about the use of
corporate bond rates for discounting is that they offer a spread over Treasury rates to compensate
for credit risk and liquidity risk. Consider the situation when Treasury rates are unchanged but
credit spreads for all AAA, AA, and A corporate bonds increase 50 basis points. An increase in
the credit spread means that the market is viewing corporate bonds as riskier from a credit
perspective. As will be explained later, the result of the 50 bps increase would result in an
improvement in the financial health of a DB pension plan. Consequently, as corporate bonds
become riskier, a DB pension plan would be better off. Despite these arguments against the use
of corporate bond rates to discount liabilities, the Pension Protection Act of 2006 allows these
rates, which are now the rules of the game.

5. Why is the funding gap of a defined benefit pension plan referred to as the unfunded
liabilities?

The funding gap is the projected value of the liabilities minus the market value of fund assets. If
we treat the liabilities as an absolute or positive number so that the funding gap is positive, then
we can say we have excess liabilities that are not accounted for which is to say they are
unfunded. Hence, the funding gap in this case represents unfunded liabilities.

6. If the funding gap of a defined benefit pension plan increases, what happens to the funding
ratio?

The funding ratio is a way of looking at the health of a DB pension plan and is defined as plans
assets as a proportion of its projected liabilities. The funding gap is defined as the projected value
of the liabilities minus the market value of fund assets. In comparing the definitions for funding
ratio and funding gap, we see that there is a negative correlation. For example, an increase in
liabilities will increase the funding gap but decrease the funding ratio. Thus, if the funding gap
increases, then the funding ratio will fall.

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7. What are the risks associated with funding gap risk?

Funding gap risk is the dollar amount by which the funding gap will increase due to adverse
changes in the factors that impact the assets and liabilities. These risks factors or types are
displayed below:

Type of Risk Asset Risk Liability Risk

interest-rate risk
inflation risk
longevity risk
credit risk
liquidity risk
currency risk
call/prepayment risk

The volatility of the funding gap depends on the volatility of the above risk factors. The concern
with the volatility of the funding gap is that regulatory funding requirements may require
additional contributions by the DB pension plan sponsor. More details are given below.

Interest-rate risk is the risk that the DB pension plans value will change due to a change in the
absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or
in any other interest rate relationship.

Inflation risk is the risk that the actual rate of inflation experienced over the DB pension plans
period will be greater than that assumed in projecting liabilities.

Longevity risk for a DB pension plan is the risk that actual life expectancy of plan members
beyond their retirement date will exceed the life expectancy assumed in projecting the liabilities.

Credit risk refers to the loss of principal stemming from failure to repay a contractual obligation.
Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt.

Liquidity risk is the risk stemming from the lack of marketability of an investment that cannot be
bought or sold quickly enough to prevent or minimize a loss. Liquidity risk is typically reflected
in unusually wide bid-ask spreads or large price movements (especially to the downside).

Currency risk is a form of risk that arises from the change in price of one currency against another.
Whenever investors or companies have assets or business operations across national borders, they
face currency risk if their positions are not hedged

Call/prepayment risk is the risk associated with the early unscheduled return of principal on a
fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have
embedded call options which may be exercised by the issuer, or in the case of a mortgage-backed
security, the borrower.

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8. What are the risks associated with the projected liabilities of a defined benefit pension
plan?

There are three risks associated with a DB pension funds projected liabilities: interest-rate risk,
inflation risk and longevity risk. See below for more details on these three risks.

The interest-rate risk for the projected liabilities can be quantified in the same way as for assets:
computing the duration for the liabilities. We refer to this duration as liability duration. Given the
long-term nature of the liabilities, liability duration for DB pension plans can range from 15 to 20
or even more. The significance of a liability duration of this magnitude is important in the
formulation of an LDI strategy because, as will be explained, hedging interest-rate risk involves
dollar-duration matching of assets and liabilities. To do so, assets with a dollar duration of close
to that of the liabilities must be available.

Inflation risk for a DB plan is the risk that the actual rate of inflation experienced over the
projection period will be greater than that assumed in projecting liabilities. The sensitivity of the
liabilities to inflation risk can be quantified by changing the inflation rate used in projecting
liabilities and then revaluing the liabilities.

Longevity risk for a DB pension plan is the risk that actual life expectancy of plan members
beyond their retirement date will exceed the life expectancy assumed in projecting the liabilities.
As a result, the amount that will actually have to be paid to the plan member will exceed the amount
projected. Although we consider longevity risk in the context of a DB pension plan, this risk is
faced by life insurance companies in pricing insurance policies and by individuals in planning their
retirement. To appreciate the significance of longevity risk, consider the change in the expected
life over the past 100+ years and the assumption of a retirement age of 65. In the United States,
the average life expectancy at birth for both sexes according to mortgage tables breaks down as
follows: 1950, 68.2 years; 1960, 69.7 years; 1970, 70.8 years; 1980, 73.7 years; 1990, 75.8 years;
2000, 77 years; 2010, 78.7 years. It is expected to be 79.5 by 2020. Hence, a plan that used an
expected life of 73.7 years in 1980 and therefore a payout of 8.7 years after age 65 would have, on
average, to make cash payments for five additional years (78.7 years minus 73.7 years) by 2010.
As with inflation risk, the sensitivity to changes in the expected life used in the projection of
liabilities and the new valuation for the liabilities based on that expected life can be used to assess
the importance of longevity risk.

9. How can the interest-rate risk of the projected liabilities of a defined benefit pension plan
be measured?

Let us ignore all risks other than interest-rate risk for projected liabilities of a defined benefit pension
plan. Doing this, we can get a first approximation for measuring the funding gaps exposure to interest-
rate risk by considering the dollar duration of the assets and liabilities. That is, the funding gap interest-
rate risk (or change in the funding gap due to interest-rate risk) equals the dollar duration of projected
liabilities minus the dollar duration of fund assets. In equation form, we have:

Funding gap interest-rate risk = Change in the funding gap due to interest-rate risk =
Dollar duration of projected liabilities Dollar duration of fund assets

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As interest rates change, the relative change in the market value of the assets and liabilities will
change depending on their respective dollar duration. If the dollar duration of the projected
liabilities exceeds that of the dollar duration of the funds assets, then a rise in interest will reduce
the funding gap as the liabilities will decline by more than the assets. The risk is with a decline in
interest rates, which will result in an increase in the funding gap. More details are given below in
form of an example.

For example, consider the following DB pension plan:

Market value of fund assets = $500 million

Projected value of liabilities = $600 million
Portfolio duration (i.e., duration of fund assets) = 7
Liability duration (i.e., duration of projected liabilities) = 12

The funding gap and funding ratio for this hypothetical plan are $100 million and 0.857 (or 85.7%
in percentage form), respectively.

Lets look at the dollar duration of the projected liabilities and fund assets assuming a 100-basis-
point-change parallel shift in interest rates:

Fund assets will change by about 7% for a 100-bp change in rates.

Projected liabilities will change by about 12% for a 100-bp change in rates.

The dollar duration (per 100 bp) change in rates is then:

Portfolio dollar duration = 7% $500 million = $35 million

Liability dollar duration = 12% $600 million = $72 million

This means that the change in the funding gap for a 100-bp change in interest rates is roughly
Change in Liability dollar duration minus Change in Portfolio (Asset) dollar duration = $72 $35
= $37 million. More specifically, the risk is that interest rates will decline. In that case, the value
of the liabilities will increase by $72 million and the value of the fund assets will increase by $35
million, increasing the funding gap by $37 million.

10. Answer the below questions.

(a) What are the difficulties of following a duration-matched strategy for hedging the
interest-rate risk of a defined benefit pension plan?

In practice there are two problems in following a duration-matched strategy for hedging the interest-
rate risk of a defined benefit pension plan. First, the duration of the liabilities may be high (e.g., more
than 20). In contrast, the duration of Treasury bonds and high-grade corporate bonds is lower (e.g.,
not close to 20). Thus, it is difficult to obtain the necessary dollar duration to hedge interest-rate risk.
So, even in the textbook illustration (with a duration of 12), the duration given is not likely to be
accomplished with high-grade bonds. The solution to address this issue is to use interest-rate

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derivatives such as futures and swaps to extend dollar duration. Consequently, a pension plan
sponsor seeking to duration match all or part of the interest-rate risk must be prepared to authorize
the use of interest-rate derivatives. Second, we have a problem in that the matching of duration
provides a hedge against interest-rate risk for a small change in interest rates. This can be dealt with
by frequent portfolio rebalancing. If interest rates move substantially between rebalancing periods,
duration matching is not sufficient as a condition for hedging. Instead, the convexity of the assets
and liabilities must be matched as closely as possible. More details are given below.

To hedge or immunize (at least as a first approximation) against interest-rate risk resulting in
adverse change in the funding gap using a bond-only portfolio, the funds portfolio can be
constructed and rebalanced so as to maintain the dollar-duration match to prevent the funding gap
from increasing. Illustrating this with our hypothetical DB pension plan, because the liability dollar
duration cannot be changed, to hedge the interest-rate risk the portfolio dollar duration must be
$72 million. Letting (Dp) denote duration for the portfolio, then for a 100-bp change in interest
rates the portfolio dollar duration is
0.01 Dp $500 million
This amount must be equal to the dollar duration of the liabilities of $72 million. That is,
0.01 Dp $500 million = $72 million
Solving, we find Dp is equal to 12. That is, the portfolio duration must be the same as the liability
duration to avoid a change in the funding gap as a result of a rise in interest rates.

The above illustration has two problems. First, it is difficult to obtain the necessary dollar duration
to hedge interest-rate risk. In our illustration, a duration of 12 is not likely to be accomplished with
high-grade bonds. Second, the matching of duration provides a hedge against interest-rate risk for
a small change in interest rates. If interest rates move substantially between portfolio rebalancing
periods, the convexity of the assets and liabilities must be matched as closely as possible.

(b) How can interest-rate derivatives be used in a bond portfolio?

Interest-rate derivatives can be used in a bond portfolio to hedge or immunize against interest-rate
risk resulting in adverse change in the funding gap using a bond-only portfolio. For example, the
duration of the liabilities can be more than 20 while, in contrast, the duration of Treasury bonds
and high-grade corporate bonds is not close to 20. Thus, it is difficult to obtain the necessary dollar
duration to hedge interest-rate risk. The solution to address this issue is to use interest-rate
derivatives such as futures and swaps to extend dollar duration. Consequently, a pension plan
sponsor seeking to duration match all or part of the interest-rate risk must be prepared to authorize
the use of interest-rate derivatives.

11. By hedging a defined benefit pension plans interest-rate risk, a sponsor can eliminate
pension risk. Comment on this statement.

Solving the interest-rate risk dilemma does not solve all potential risk associated with managing a
pension fund. Besides interest-rate risk, other risks are associated with a pension fund. For
example, besides interest-rate risk, there are two other associated with a defined benefit pension

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funds projected liabilities. First, there is inflation risk. Second, there is longevity risk. Below we
describe these risks.

Inflation risk for a DB pension plan is the risk that the actual rate of inflation experienced over
the projection period will be greater than that assumed in projecting liabilities. The sensitivity of
the liabilities to inflation risk can be quantified by changing the inflation rate used in projecting
liabilities and then revaluing the liabilities.

Longevity risk for a DB pension plan is the risk that actual life expectancy of plan members
beyond their retirement date will exceed the life expectancy assumed in projecting the liabilities.
As a result, the amount that will actually have to be paid to the plan member will exceed the amount
projected. Although we consider longevity risk in the context of a DB pension plan, this risk is
faced by life insurance companies in pricing insurance policies and by individuals in planning their
retirement. As with inflation risk, the sensitivity to changes in the expected life used in the
projection of liabilities and the new valuation for the liabilities based on that expected life can be
used to assess the importance of longevity risk.

12. What alternative LDI solution can be used to manage a defined benefit pension plan
instead of managing just interest-rate risk?

Three solutions have been used by sponsors of DB pension plans to mitigate the risks that they
face. These solutions, referred to as de-risking solutions, are closing (freezing), termination and
risk transference. Below we describe these strategies. Basically, these solutions are a means for
dealing with longevity risk, which is the risk that actual life expectancy of plan members beyond
their retirement date will exceed the life expectancy assumed in projecting the liabilities.

Closing a fund plan means freezing the plan, not terminating it. The plan remains insured by the
federal insurer, the Pension Guaranty Benefit Corporation (PGBC). There are three types of plan
freezes:

Hard freeze: All employees may not earn any further benefits under the plan but employees
become immediately vested in what they have earned.
Partial freeze: The benefits may not increase for some but not all employees. This typically
occurs when an employer does not allow new employees to enroll in the plan, but continues
the plan for existing employees.
Soft freeze: Employees are no longer allowed to obtain pension credit for future years of
work under the plan, but they are allowed their benefits to be figured on their pay at the
time they leave the plan, rather than at the date of the freeze.

A frozen plan can be unfrozen at the election of the employer.

The termination of a plan results in the plan operations stopping completely and cannot be
unterminated. What happens to the plans assets and the payments to the members of the plan
depends on whether the plan is underfunded or overfunded. For an underfunded pension plan, the
assets are turned over to the PBGC. That federal insurer will then make the promised payments to
the plan members (subject to federal restrictions as to the maximum amount a plan member may

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be paid). If in the unlikely case the plan is overfunded, the plan assets will be transferred to a
qualified insurer that will then be responsible for making the full benefit payments to the plan
members.

Pension sponsors can buy out the vested employees with a lump-sum payment. This removes all
pension risk associated for that one group of members. This solution transfers pension risk to the
members who accept the lump-sum payment.

Other risk transference solutions include buy-outs, buy-ins, and longevity swaps. In a buy-out, the
sponsor purchases for a single premium an insurance contract (an annuity contract) for all
employees. This transfers the pension risk from the plan sponsor to the issuer of the annuity
(usually a life insurance company). This solution is referred to as annuitization. Although the
standard pension risk has been removed, there is still the credit risk of the counterparty.

With a buy-in, the plan sponsor purchases for a single premium an annuity that does not cover the
full amount of the projected liabilities. The assets in the fund not used to purchase an annuity are
still managed by the plan sponsor, so there is only a partial transference of the pension risk. The
annuity becomes an asset of the pension plan with the associated credit risk like that of any
corporate debt obligation.

The hedging of longevity risk can be obtained by the pension plan entering into a longevity swap
or a longevity bond. With a longevity swap, the pension plan enters into a swap agreement with a
counterparty, usually an investment bank or an insurer. The pension plan pays in this swap
transaction a fixed amount periodically to the counterparty and the counterparty makes periodic
floating payments to the pension plan based on the difference between actual and expected
mortality experience. There are different types of longevity swaps: customized and standardized
(or index-linked instruments). The risk with standardized longevity swaps is that the contract may
not provide precisely the longevity risk faced by the pension plan.

13. In December 2003, a European insurance company, Swiss Re, issued a 3-year floating-
rate bond maturing on January 1, 2007, with a par value of US$400 million. The interest-
rate payments were quarterly with a coupon reset formula of 3-month U.S. LIBOR plus 135
basis points. The principal at maturity was linked to a specifically constructed index of
mortality rates (i.e., mortality index) across five countries (United States, United Kingdom,
France, Italy, and Switzerland). The principal schedule at maturity called for repayment in
full if the mortality index does not exceed 1.3 times the 2002 base level during any of the
three years of the life of the bond. However, if the mortality index exceeded that level, there
would be an increase of 5% for every change in the index by 0.01.

(a) What was the purpose of Swiss Re issuing this bond?

The purpose of Swiss Re issuing this bond (an asset) is to cover its maturing liabilities in three
years. Due to uncertainties in the liabilities, the bond is arranged to cover risk aspects such as
unexpected changes in longevity and inflation. More details are supplied below.

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A liability-driven investing (LDI) involves managing the assets and the liabilities. Assets have
investment risks and, as we will see, so do liabilities. LDI is used by life insurance companies (like
Swiss Re) for several products: annuities, guaranteed investment contracts (GICs), and structured
contracts that guarantee a minimum rate. It is also used by sponsors of defined benefit (DB)
pension plans. Longevity risk is a major risk faced by life insurance companies in pricing insurance
policies and by individuals in planning their retirement. To appreciate the significance of longevity
risk, consider the change in the expected life over the past 100+ years and the assumption of a
retirement age of 65. In the United States, the average life expectancy at birth for both sexes
according to mortgage tables breaks down as follows: 1950, 68.2 years; 1960, 69.7 years; 1970,
70.8 years; 1980, 73.7 years; 1990, 75.8 years; 2000, 77 years; 2010, 78.7 years. It is expected to
be 79.5 by 2020. Hence, a plan that used an expected life of 73.7 years in 1980 and therefore a
payout of 8.7 years after age 65 would have, on average, to make cash payments for five additional
years (78.7 years minus 73.7 years) by 2010. As with inflation risk, the sensitivity to changes in
the expected life used in the projection of liabilities and the new valuation for the liabilities based
on that expected life can be used to assess the importance of longevity risk.

There are strategies for hedging the interest-rate risk of liabilities such as Swiss Re face. One
strategy is referred to as the single-period immunization strategy. While not used by DB pension
plans to hedge interest-rate risk (because it involves hedging only a single liability payment in the
future), this strategy is used by life insurance companies (like Swiss Re) to hedge the interest-rate
risk of a popular insurance product: a guaranteed interest contract (GIC). In fact, GIC products are
sold by life insurance companies to DB pension plans.

To comprehend the basic principles underlying the immunization of a portfolio against interest-
rate changes so as to satisfy a single future liability, consider the situation faced by a life insurance
company that sells a GIC. Under this policy, for a lump-sum payment, an insurer guarantees that
specified dollars will be paid to the policyholder at a specified future date. Or, equivalently, the
insurer guarantees a specified rate of return on the payment. A stream of liabilities must also be
satisfied for a life insurance company that sells an insurance policy requiring multiple payments
to policyholders, such as an annuity policy. Two strategies can be used to satisfy a liability stream:
(1) multi-period immunization, and (2) cash flow matching

(b) The Swiss Re bond is referred to as a catastrophe bond. Why?

Swiss Res bond is referred as a catastrophe bond (or CAT) because it has characteristics related
to what is commonly associated with a company who wants to avoid a potential disaster if there
are extraordinary changes in factors that influence paying off liabilities. By definition, a
catastrophe bond is a high-yield debt instrument that is usually insurance linked and meant to raise
money in case of a catastrophe such as an event in nature like hurricane or earthquake or an event
that affects the financial markets like unexpected and dramatic changes in interest rates. A CAT
has a special condition that states that if the issuer (insurance or reinsurance company) suffers a
loss from a particular pre-defined catastrophe, then the issuer's obligation to pay interest and/or
repay the principal is either deferred or completely forgiven.

Advantages of CAT bonds are that they are not closely linked with the stock market or economic
conditions and offer significant attractions to investors. For example, for the same level of risk,

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investors can usually obtain a higher yield with CAT bonds relative to alternative investments.
Another benefit is that the insurance risk securitization of CATs shows no correlation with equities
or corporate bonds, meaning they'd provide a good diversification of risks.

14. Answer the below questions.

(a) Why is the interest-rate sensitivity of a defined benefit pension plans assets and liabilities
important?

Knowing the interest-rate sensitivity of a defined benefit pension plans assets and liabilities is
important because it can reveal the steps that a firms manager needs to perform to avoid financial
difficulties associated with being short of assets relative to liabilities.

To see why the interest-rate sensitivity of an institutions assets and liabilities important, consider
an institution that has a portfolio consisting only of bonds and liabilities. If interest rates rise, both
the bonds and liabilities will decline in value. However, the funding gap can increase, decrease, or
not change. The net effect on the funding gap depends on the relative interest rate sensitivity of
the assets compared to the liabilities. If the dollar duration of the projected liabilities exceeds that
of the dollar duration of the funds assets, then a rise in interest will reduce the funding gap as the
liabilities will decline by more than the assets. The risk is with a decline in interest rates, which
will result in an increase in the funding gap.

(b) In 1986, Martin Leibowitz wrote a paper titled Total Portfolio Duration: A New
Perspective on Asset Allocation. What do you think total portfolio duration means?

One would think that total portfolio duration refers to the duration of all assets and liabilities
together. If bonds in the portfolio are all assumed to be option-free bonds, total portfolio duration
means modified duration can be used to measure duration. However, when portfolios include
securities with embedded options, the effective duration is used. For most institutional portfolios,
total portfolio duration will likely refer to effective duration.

15. If a defined benefit pension plan has liabilities that are interest-rate sensitive and the plan
sponsor allows investment in a portfolio of common stocks, can you determine what will
happen to its funding gap if interest rates change?

The stock market is generally influenced like bonds and other fixed-income securities when
interest rates change. That is, stock values fall when interest rates increase and values rise when
rates fall. However, there is much more volatility for common stocks than for fixed-income
securities. Although it would involve some difficulty to predict any precise relationship between
common stock and the institutions funding gap if interest rates change, generally one can say that
assets would be more volatile relative to liabilities. In conclusion, if interest rates went down then
assets would go up more than liabilities giving having a positive effect by decreasing the funding
gap; the opposite would occur if rates went up.

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16. 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. 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.

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 plans 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.

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17. In explaining how a pension fund should transition to a liability-driven investment
strategy, Duane Rocheleau, managing director of Northern Trusts global investment
solutions team, writes in Implementing LDI in Pension Plans, January 2007:
1. Analyze and characterize the liabilities;
2. Quantify the relationship between the assets and liabilities;
3. Develop and implement appropriate investment strategies;
4. Monitor the account, rebalance the assets and liabilities mix and tweak the investment
strategy as necessary.

Describe each of the above elements.

In terms of analyzing and characterizing the liabilities, the manager wants to know the amounts of
cash flows and the timing of the cash flows that are owed pension fund recipients. This is needed
to determine what kinds and proportion of funds to allocate to asset types. For example, a
diversified mix of asset types with a significant commitment to one type of assets might then be
judged to offer the highest probability of building assets, containing costs and meeting the plans
obligations.

In terms of quantifying the relation between the assets and liabilities, the manager wants to be able
to match the cash flows from the assets with those of the liabilities so that pension fund recipients
will be paid in full and on time. To understand this problem and the need to quantify, consider
duration. We can note that for many pension plans, the duration of the liabilities is quite long
ranging from twelve years on up to even over twenty years. The duration provides an estimate of
how the liability will change as a result of a one percent parallel shift in the yield curve. A plan
with a liability duration of ten years could expect to see liabilities grow by approximately ten
percent if interest rates dropped by one percent. Over periods of time, interest rates have dropped
by far more than one percent for a number of consecutive years. In light of this, it becomes
important that we match the duration for assets and liabilities.

In regards to developing and implementing appropriate investment strategies, there are two
strategies to choose from: multi-period immunization and cash flow matching.

A multi-period immunization strategy is one in which a portfolio is created that will be capable of
satisfying more than one predetermined future liability regardless if interest rates change. Even if
there is a parallel shift in the yield curve, it has been demonstrated that matching the duration of
the portfolio to the duration of the liabilities is not a sufficient condition to immunize a portfolio
seeking to satisfy a liability stream. Instead, it is necessary to decompose the portfolio payment
stream in such a way that each liability is immunized by one of the component streams. The key
to understanding this approach is recognizing that the payment stream on the portfolio, not the
portfolio itself, must be decomposed in this manner. There may be no actual bonds that would give
the component payment stream.

A cash flow matching strategy is used to construct a portfolio that will fund a schedule of liabilities
from a portfolio's cash flows, with the portfolio's value diminishing to zero after payment of the

619
last liability. This strategy can be summarized as follows. A bond is selected with a maturity that
matches the last liability stream. An amount of principal plus final coupon equal to the amount of
the last liability stream is then invested in this bond. The remaining elements of the liability stream
are then reduced by the coupon payments on this bond, and another bond is chosen for the new,
reduced amount of the next-to-last liability. Going backward in time, this cash flow matching
process is continued until all liabilities have been matched by the payment of the securities in the
portfolio.

In regards to further action (monitoring, rebalancing, and tweaking) on the investment strategy as
necessary, we can note that action is required because the market yield will fluctuate over the
investment horizon. As a result, the duration of the portfolio will change (and change by more than
that caused simply by the passage of time). In the face of changing yields, a portfolio can maintain
immunization by rebalancing so that its duration is equal to the duration of the liabilitys remaining
time. For example, if the liability is initially five years, the initial portfolio assets should have a
duration of five years. After a year, the duration for the liabilities and assets will change and it is
unlikely they will be matched. This is because duration depends on the remaining time to maturity
and the new level of yields, and there is no reason why the change in these two values should
change the duration by the exact amount of time. Thus, the portfolio must be rebalanced.

A question we can pose is: How often should the portfolio be rebalanced to adjust its duration?
On the one hand, the more frequent rebalancing increases transactions costs, thereby reducing the
likelihood of achieving the target yield. On the other hand, less frequent rebalancing will result in
the duration wandering from the target duration, which will also reduce the likelihood of achieving
the target yield. Thus, the portfolio manager faces a trade-off: some transaction costs must be
accepted to prevent the duration from wandering too far from its target, but some maladjustment
in the duration must be accepted or transaction costs will become prohibitively high.

18. What is meant by immunizing a bond portfolio?

Immunizing a bond portfolio means that the portfolios value is protected against a general change
in the rate of interest. More details are given below.

Investing in a coupon bond with a yield to maturity equal to the target yield and a maturity equal
to the investment horizon does not assure that a portfolios target accumulated value will be
achieved. This is because an increase in the market yield causes the market value to fall and the
portfolio can fail to achieve the target accumulated value. This can occur when the fall in principal
is greater than any increase in reinvestment rate. In other words the interest rate (or price) risk has
a greater impact that the reinvestment risk. To avoid this loss (and immunize its portfolio from
interest rate changes), the portfolio manager should look for a coupon bond so that however the
market yield changes, the change in the interest on interest will be offset by the change in the price.

The equality of the duration of the asset and the duration of the liability is the key to immunization.
When generalizing this observation to portfolios, the key is to immunize a portfolios target
accumulated value (target yield). To do this, a portfolio manager must construct a bond portfolio
such that the duration of the portfolio is equal to the duration of the liability, and the present value
of the cash flow from the portfolio equals to the present value of the future liability.

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19. Answer the below questions

(a) What is the basic underlying principle in an immunization strategy?

The basic underlying principle in an immunization strategy is to have the duration of the asset
equal the duration of the liability. Generalizing this observation to bond portfolios from individual
bonds, the key principle is: To immunize a portfolios target accumulated value (target yield), a
portfolio manager must construct a bond portfolio such that (i) the duration of the portfolio is equal
to the duration of the liability, and (ii) the present value of the cash flow from the portfolio equals
to the present value of the future liability.

(b) Why might the matching of the maturity of a coupon bond to the remaining time to
maturity of a liability fail to immunize a portfolio?

Investing in a coupon bond with a yield to maturity equal to the target yield and a maturity equal
to the investment horizon does not assure that a portfolios target accumulated value will be
achieved. This is because an increase in the market yield causes the market value to fall and the
portfolio can fail to achieve the target accumulated value. This can occur when the fall in principal
is greater than any increase in reinvestment rate. In other words the interest rate (or price) risk has
a greater impact that the reinvestment risk. To avoid this loss (and immunize its portfolio from
interest rate changes), the portfolio manager should look for a coupon bond so that however the
market yield changes, the change in the interest on interest will be offset by the change in the price.

20. Why must an immunized portfolio be rebalanced periodically?

The key to immunizing a portfolio of assets is to match the duration of the assets with the liabilities.
Because market yields can change periodically affecting the duration of the assets, the portfolio of
assets must be rebalanced periodically to insure immunization. More details are given below.

Illustrations of the principles underlying immunization often assume a one-time instantaneous

change in the market yield. In practice, the market yield will fluctuate over the investment horizon.
As a result, the duration of the portfolio will change as the market yield changes. In addition, the
duration will change simply because of the passage of time.

Even in the face of changing market yields, a portfolio can be immunized if it is rebalanced so that
its duration is equal to the duration of the liabilitys remaining time. For example, if the liability is
initially 5.5 years, the initial portfolio should have a duration of 5.5 years. After six months the
liability will be five years, but the duration of the portfolio will probably be different from five years.
This is because duration depends on the remaining time to maturity and the new level of yields, and
there is no reason why the change in these two values should reduce the duration by exactly six
months. Thus the portfolio must be rebalanced so that its duration is five years. Six months later the
portfolio must be rebalanced again so that its duration will equal 4.5 years. And so on.

There is the question of how often the portfolio should be rebalanced to adjust its duration. On the
one hand, the more frequent rebalancing increases transactions costs, thereby reducing the

621
likelihood of achieving the target yield. On the other hand, less frequent rebalancing will result in
the duration wandering from the target duration, which will also reduce the likelihood of achieving
the target yield. Thus the portfolio manager faces a tradeoff in that some transactions costs must
be accepted to prevent the duration from straying from its target, but some adjustment in the
duration must be accepted or transactions costs will become prohibitively high.

21. What are the risks associated with a bond immunization strategy?

As described below, there are risks that can upset various types of bond immunization strategies.

A first risk involves uncertainty as to how the yield curve might shift. For example, if there is a
change in interest rates that does not correspond to the shape-preserving shift, matching the
portfolios duration to the liabilitys duration will not assure immunization. The sufficient
condition for the immunization of a single liability is that the duration of the portfolio be equal to
the duration of the liability. However, a portfolio will be immunized against interest-rate changes
only if the yield curve is flat and any changes in the yield curve are parallel changes (i.e., interest
rates move either up or down by the same number of basis points for all maturities). Duration is a
measure of price volatility for parallel shifts in the yield curve. If there is a change in interest rates
that does not correspond to this shape-preserving shift, matching the portfolios duration to the
liabilitys duration will not assure immunization. That is, the target yield will no longer be the
minimum total return for the portfolio.

A second risk involves the reinvestment rate. For example, consider the example in the text where
the accumulated value for a barbell portfolio at the liability due date misses the target accumulated
value by more than a bullet portfolio. There are two reasons for this. First, the lower reinvestment
rates are experienced on the barbell portfolio for larger interim cash flows over a longer time period
than on the bullet portfolio. Second, the portion of the barbell portfolio still outstanding at the end
of the liability due date is much longer than the maturity of the bullet portfolio, resulting in a
greater capital loss for the barbell than for the bullet. Thus the bullet portfolio has less risk exposure
than the barbell portfolio to any changes in the interest-rate structure that might occur.

What should be evident from this analysis is that immunization risk is the risk of reinvestment.
The portfolio that has the least reinvestment risk will have the least immunization risk. When there
is a high dispersion of cash flows around the liability due date, the portfolio is exposed to high
reinvestment risk. When the cash flows are concentrated around the liability due date, the portfolio
is subject to low reinvestment risk.

22. I can immunize a portfolio simply by investing in zero-coupon Treasury bonds.

Comment on this statement.

If all the cash flows are received at the liability due date, the immunization risk measure is zero.
In such a case the portfolio is equivalent to a pure discount security (zero-coupon security) that
matures on the liability due date. If a portfolio can be constructed that replicates a pure discount
security maturing on the liability due date, that portfolio will be the one with the lowest
immunization risk. Typically, however, it is not possible to construct such an ideal portfolio. More
details are given below.

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An alternative approach to immunizing a portfolio against changes in the market yield is to invest
in zero-coupon bonds with a maturity equal to the investment horizon. This is consistent with the
basic principle of immunization, because the duration of a zero-coupon bond equals the liabilitys
duration. However, in practice, the yield on zero-coupon bonds is typically lower than the yield on
coupon bonds. Thus using zero-coupon bonds to fund a bullet liability requires more funds,
because a lower target yield (e.g., yield on the zero-coupon bond) is being locked in.

Suppose, for example, that a portfolio manager must invest funds to satisfy a known liability of
$20 million five years from now. If a target yield of 10% on a bond-equivalent basis (5% every
six months) can be locked in using zero-coupon Treasury bonds, the funds necessary to satisfy the
$20 million liability will be $12,278,260, the present value of $20 million using a discount rate of
10% (5% semiannually).

Suppose, instead, that by using coupon Treasury securities, a target yield of 10.3% on a bond-
equivalent basis (5.15% every six months) is possible. Then the funds needed to satisfy the $20
million liability will be $12,104,240, the present value of $20 million discounted at 10.3% (5.15%
semiannually). Thus a target yield higher by 30 basis points would reduce the cost of funding the
$20 million by $12,278,260 $12,104,240 = $174,020. But the reduced cost comes at a price
the risk that the target yield will not be achieved.

23. Why is there greater risk in a multi-period immunization strategy than a cash flow
matching strategy?

To understand the greater risk in a multi-period immunization strategy, we need to first understand
the differences between the cash flow matching and multi-period immunization strategies. First,
unlike the immunization approach, the cash flow matching approach has no duration requirements.
Second, with immunization, rebalancing is required even if interest rates do not change. In contrast,
no rebalancing is necessary for cash flow matching except to delete and replace any issue whose
quality rating has declined below an acceptable level. Third, there is no risk that the liabilities will
not be satisfied (barring any defaults) with a cash flow-matched portfolio. For a portfolio constructed
using multi-period immunization, there is immunization risk due to reinvestment risk.

The differences just cited may seem to favor the use of cash flow matching. However, what we
have ignored is the relative cost of the two strategies. Cash flow matching is more expensive
because, typically, the matching of cash flows to liabilities is not perfect. This means that more
funds than necessary must be set aside to match the liabilities. Optimization techniques used to
design cash flow-matched portfolios assume that excess funds are reinvested at a conservative
reinvestment rate. With multi-period immunization, all reinvestment returns are assumed to be
locked in at a higher target rate of return.

In conclusion, portfolio managers face a trade-off in deciding between the two strategies:
avoidance of the risk of not satisfying the liability stream under cash flow matching versus the
lower cost attainable with multi-period immunization.

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