Characteristics of Liabilities Relevant to Asset Allocation

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:

• Fixed or contingent cash flows: Fixed cash flows remain the same period by period, whereas contingent cash flows change depending on a reference, often LIBOR or the federal funds rate. Planning for fixed cash is much simpler.
• Legal or quasi-legal liabilities: Not all cash flows are required by law. For example, making benefit payments for a defined benefit pension plan is legally required. These should take precedence over any quasi-legal liabilities.
• Duration and convexity: Duration and convexity help explain how a liability’s value may change given changes in interest rates. These factors are essential to model and take into consideration to more precisely estimate a variable future liability.
• Value of liabilities as a percentage of the organization’s size: Large liabilities should take precedence over smaller liabilities, which may have little effect on the asset allocation decision.
• Factors driving future liability cash flows: These include inflation, economic conditions, interest rates, risk premiums, etc.
• Timing considerations: These could include longevity risk, which refers to the chance that retirees may continue living longer in the future, thus jeopardizing their ability to live their entire lives fully sustained by a portfolio.
• Regulations: These are common to the insurance industry and must be considered. A portfolio must meet legal requirements to be of optimal use.

Question

The presence of longevity risk in a liability would least likely:

1. Decrease the liability’s present value.
2. Increase liability’s present value.
3. 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. 

Asset Allocation: Learning Module 4: Principles of Asset Allocation; Los 4(j) Describe and evaluate characteristics of liabilities that are relevant to asset allocation