Liability-Based Benchmarks

Liability-based benchmarks are created from the perspective of cash flow needs. The cash flow needed from the assets in order to fund a future liability is the focus. Using this metric, managers can see how much of a particular liability has been funded by the assets, and thus judge their performance. This type of benchmark is popular with pension funds, where managers track funded status. The amount by which the assets of the plan exceed the expected future liabilities.

Another similar idea is liability-driven investment (LDI) indexes. The Bloomberg Barclays LDI Index Series is a series of six investible indexes designed specifically for portfolios intended to hedge pension liabilities. However, they may not describe a plan's liability structure as accurately as a benchmark constructed specifically for the plan. To best determine how a liability-based benchmark should be constructed, the manager first needs to understand the nature of the plan's liabilities and the plan's projected future cash flows. Although each plan will have its own unique characteristics, the following plan features will influence the structure of the liability:

1. The average number of years to retirement in the workforce.
2. Percentage of the workforce that is retired.
3. Average participant life expectancy.
4. Benefits are indexed to inflation.
5. Plan offers an early retirement option.
6. Possibility to increase its plan contributions.
7. Correlation between plan assets and the sponsoring company's operating assets.
8. Going concern status.

These characteristics influence the composition of the pension plan portfolio and hence its liability-based benchmark. The allocation to each asset class within the portfolio is driven by the proportion of accrued versus future obligations, whether the benefits are inflation-indexed, and whether the plan is growing. For example:

• A younger workforce means that more is allocated to equities.
• Greater inflation indexing of the benefits would imply more inflation-indexed bonds.

If the fund's managers beat the benchmark constructed according to these principles, the pension obligations should be met.

Question

Which of the following is a plan feature that would affect the structure of the associated liability?

1. Manager's expected equity returns.
2. Benefits which are indexed to inflation.
3. Tax law changes.

Solution

The correct answer is B.

However, the structure of a liability refers to the way the liability itself has been set up. For example, will the payments be made at a flat rate, or indexed to some economic variable (i.e., inflation)? Or how long will the payments continue? These are questions that refer to the structure, or makeup of the liability itself.

A and C are incorrect. Both are expectations about future outcomes. These may influence the asset allocation of the plan, in the case that the manager has leeway to invest the funds based on those (think: Surplus Optimization).

Reading 12: Portfolio Performance Evaluation

Los 12 (i) Discuss uses of liability-based benchmarks