Asset Class Allocation
Three Super Classes An asset class is a group of assets that all... Read More
Aside from the well-known asset-only approach to asset allocation, other options are available to financial professionals. Another lens to view asset allocation involves thinking not of an already constructed portfolio of assets but first viewing the liabilities under the portfolio’s purview, and then creating an asset allocation to satisfy those liabilities as they arise. This is known as a liability-relative approach to asset allocation.
Liabilities are not homogenous in the real world. The following characteristics of liabilities that affect asset allocation in liability-relative asset allocation are thought to be the most prominent:
Question
The presence of longevity risk in a liability would least likely:
- Decrease the liability’s present value.
- Increase liability’s present value.
- Complicate timing considerations.
Solution
The correct answer is A:
Liability is what funds a retirement in the case of pension funds. For example, the present value of pension benefit obligations is a collective liability to a firm that will pay for all its current retirees’ living expenses. When longevity risk is present, retirees live longer, and the present value of that needed cash flow stream grows. This also extends the time it must be paid, complicating timing considerations.
B is incorrect. As a result of longevity risk, a liability’s present value could increase, as the liability holder would need to account for the possibility that the liability may need to be paid for a more extended period than anticipated.
C is incorrect. Pension funds or insurance companies face a longevity risk when life expectancies or mortality rates are incorrect. Due to this risk, it is difficult to predict the exact amount of time the liability will need to be paid, complicating the timing considerations.
Reading 5: Principles of Asset Allocation
Los 5 (j) Describe and evaluate characteristics of liabilities that are relevant to asset allocation