Linking Pension Liabilities to Assets

2 Pension assets exist to defease the benefit promises made by plan sponsors to participants and beneficiaries—in other words, the pension liability. It follows that pension investment policies should be set in a way that explicitly integrates the exposures of the pension liability. The traditional approach to pension investing has excluded the risks of the liability, which has resulted in portfolios that may be appropriate in an asset-only framework, but that are exposed to unrewarded risk when evaluated relative to liabilities. Efficient investment policies can be designed to avoid unrewarded risk if the exposures of the liability are explicitly integrated into the investment framework. The intent of this paper is twofold: • To provide insight into modeling the pension liability, and focus on which fundamental and economic factors influence its evolution. • Using the fundamental and economic factors that influence both assets and the pension liability, to provide a framework to model assets and liabilities consistently. While we focus on pension plans, the general framework put forth to link assets and liabilities via fundamental and economic factors is applicable to many situations where assets are set aside to defease a future obligation that has market-related exposures. Thus, the framework can be generalized to insurance products, postretirement health benefits, or college savings plans.