The risk management of distinct benefit pension assets centres on the plan?s liabilities, since those assets subsist exclusively to endow the liabilities. What liability characteristics should we consider? Assets and liabilities mutually influence three fundamental drivers: The amount and timing of contributions requisite from the sponsor. The pension outlay that is traced on the sponsor?s income statement, and Security of the promised benefits or the plan?s funded position. Assets are simple to comprehend; unlike liabilities, since there are diverse measures. Some measures are marked to markets and respond directly to altering bond yields and inflation expectations. Some are smoothed. Some replicate current pay levels while others use potential pay. Some reflect promised indexing whereas others don?t. Liabilities marked to market resemble long bonds. Smoothed liabilities have no such complement, maybe cash but with a superior yield. Liabilities based on current pay resemble nominal long bonds. Liabilities based on projected pay resemble some combination of nominal and real-return bonds.

Recognize that the first two key drivers work off the third, the funded arrangement. Appreciate that this driver will budge unfavorably at times and establish the sponsor?s tolerance to adverse tendencies. Glancing at the short term, you could game nominal bonds to the liabilities.

Over the longer term, this would unduly expose the sponsor to solvency shortfalls and consequent cash calls if inflation surges beyond expectations. Mixing in real return bonds would offer a better medium to long-term match, but they are scarce. There is no single answer, but a logical course for determining the bond-equities split and how those bonds should appear.

The initial step is to design a risk-minimizing portfolio matched to the appropriate liability measure and time horizon. This will likely be some blend of nominal and real-return bonds. Realize that one cannot purge all hazards. This ?safe? design ensures promised benefits can be paid based on current expectations. Unforeseen demographic changes, perhaps extended longevity or too many early retirements, remain a wild card.

Consider how you might reduce the expected long-term cost by altering the mix to include riskier assets such as equities. Based on the sponsor?s ability to absorb short-term shocks, what?s the optimal split between risk minimizers and return generators? How easily can the sponsor handle the strain of a pension solvency cash call whilst business is down?

Constructing the riskier portion of the portfolio based on how various types of assets would enhance return or diversify risk. Instead of gauging volatility in relation to an index or peer group, focus on the projected deviation from the return required to keep the plan in poise. For instance, earning 18 % when the market delivers 20 % matters less than losing 10 % when the market falls 8 %.

Ultimately, the goals of risk management are centred on liabilities. The most important is to guarantee promised benefits can be paid as they come due. Additionally, the sponsor must maintain the ongoing funding requirement from becoming excessively burdensome. So, when structuring assets, think liabilities.

<B>Nitish BENIMADHU</B>

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