CFA CFA Level 3 Linking Pension Liabilities to Assets

Linking Pension Liabilities to Assets

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    • AjFinance
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      Just thought the following was a bit contradicting, I kind of worked up an explanation. Would like to hear it if anyone can explain/describe it better.

      Nominal Return = Real Return + Inflation
      Real Return = Nominal Return – Inflation component

      When trying to fund future pension obligations, the wage increases that might be attributable to inflation are hedged with Real Return Bonds. Also, the wage increases that are not really related to inflation can be hedged with Nominal Return Bonds.

      1. Now I realise that Real Return Bonds include debt instruments like TIPS which explicitly offer inflation protection, they are designed to hedge that risk. But won’t a nominal return bond do the same thing as they include an inflation component?

      2. Real Return Bonds offer protection against “unexpected” inflation as well. Whereas, Nominal Return Bonds incorporate only the “expected” inflation assumption in their rate of return. Is it due to this fact that Real Return Bonds are a preferred source for hedging liabilities, assumed to be influenced by inflation?

      I am thinking that point no.2 explains it. Additional insights and explanations would be welcome. Any thoughts?

    • Zee Tan
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      @AJFinance your point 2 nails it (I think). All bonds will always offer protection against ‘expected’ inflation – not necessarily in their rate of return, but their pricing. Bond pricing is heavily dependent on risk free rate, of which inflation will be a necessary factor. In fact, any financial instrument or investment will incorporate a current view of inflation expectations – otherwise it’s not a good instrument!

      However, you’re right about point 2 – it’s unforeseen changes in inflation that a Real Return Bond hedges against. A nominal bond only looks at rates/coupons on a nominal level (e.g. fixed rate, LIBOR, etc). A Real Return Bond would have payouts fixed to an actual inflation index (i.e. an index that reacts to changes in inflation levels).

      In my view, not every bond is distinctly a nominal or real return bond. LIBOR etc inherently incorporates a bit of inflation, and inflation indices aren’t perfect.

      I agree the issue does get a bit confusing once you talk about pension accounting and wages. I welcome more details and a further discussion if you like! 😀

    • AjFinance
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      @zee yep it does get really confusing, and more so when combined with pension accounting @-) Well the more you beat the topic down, the clearer it gets 😉

    • Zee Tan
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      @ajfinance if you have a particular question just shoot it here 🙂

    • AjFinance
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      @Zee sure. Right now I’m hoping we can get more insights/opinions on this question though.

    • Sophie Macon
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      Ok, having a go at this.

      First, I must admit I’m not sure what this statement really means…

      When trying to fund future pension obligations, the wage increases that might be attributable to inflation are hedged with Real Return Bonds. Also, the wage increases that are not really related to inflation can be hedged with Nominal Return Bonds.

      But nevertheless, it shouldn’t affect both the statements.

      1. Now I realise that Real Return Bonds include debt instruments like TIPS which explicitly offer inflation protection, they are designed to hedge that risk. But won’t a nominal return bond do the same thing as they include an inflation component?

      Nominal return bonds includes an expected inflation component. So you won’t know your real yield on a nominal bond until maturity, where you know the actual inflation over that period. That is the source of inflation risk and uncertainty. With Real Return Bonds (RRB), you have perfect hedge of inflation, as the essence of RRB is that the real yield is guaranteed (vs. nominal bonds where nominal yield is guaranteed).

      How does this work? RRB differ in 2 ways generally, first the principle accrues with inflation throughout the life of the bond, and secondly the coupon is based on a (generally lower) real rate of return. Hence, the real-return-based coupon payment is applied on the inflation-accrued principle – thus both principle and couple are hedged from inflation. This is not the same for nominal return bonds where unexpected deviations of inflation are not accounted for. Therefore you’d expect the nominal yield to be higher due to inflation risk premium as well.

      2. Real Return Bonds offer protection against “unexpected” inflation as well. Whereas, Nominal Return Bonds incorporate only the “expected” inflation assumption in their rate of return.

      You arrive at similar conclusions here.

      Is it due to this fact that Real Return Bonds are a preferred source for hedging liabilities, assumed to be influenced by inflation?

      But it’s not due to RRB being a preferred source for hedging liabilities. You choose a hedging instrument suitable to (ideally perfectly) offset the risk of your liabilities. Asset/liability mismatch occur when assets and liabilities are exposed to different risk factors OR are affected to different degree through the same risk factors. So no hard and fast rule here. Plus if the goal is to minimise pension funding shortfall, the asset risk should mimic liabilities, I would have thought. Investing in RRB when liabilities are affected by inflation increases the mismatch?

      I hope this makes more sense? Happy to discuss

    • AjFinance
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      @Sophie. I’m sorry couldn’t simplify it more 🙂

      In the initial statement, I was just providing a premise for the discussion. Usually, when taking into account the future increases in pension obligations, the future wage/salary increases are either correlated/uncorrelated to inflation.

      So those increases (liabilities) that are usually correlated to inflation are said to be better matched against assets that are indexed to inflation (RRB).

      Both the similar statements are part of the same point (Point 2).

    • AjFinance
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      I got this point. Thanks @Sophie. It somewhat confirms with the 2nd point. But you explained it further :)>-

      How does this work? RRB differ in 2 ways generally, first the principle accrues with inflation throughout the life of the bond, and secondly the coupon is based on a (generally lower) real rate of return. Hence, the real-return-based coupon payment is applied on the inflation-accrued principle – thus both principle and couple are hedged from inflation. This is not the same for nominal return bonds where unexpected deviations of inflation are not accounted for. Therefore you’d expect the nominal yield to be higher due to inflation risk premium as well.

      I would have thought. Investing in RRB when liabilities are affected by inflation increases the mismatch?

      The text does mention that RRB is the way to go to match the liabilities that are affected by inflation. Isn’t it contradicting your initial statement?

    • Sophie Macon
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      If there’s a particular question let me know @AjFinance. Works better through application. I need to make sure I’m right as well in my explanation, been rusty!

    • AjFinance
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      @Sophie, you explanation does clear it. But I was a bit confused about this last statement.

      ” I would have thought. Investing in RRB when liabilities are affected by inflation increases the mismatch?”

      Because schweser text mentions that RRB do match the liabilities affected by inflation better.

    • Sophie Macon
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      @Ajfinance, my assumption here is that liabilities are not inflation indexed. If they are, e.g. wages are inflation-indexed, then RRB would be a good hedge. But yes, some pension funds do offer that inflation-indexing of future benefits.

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