Risk Moment RES

THE “RIGHT WAY” TO VIEW

THE ASSET/LIABILITY PUZZLE

The way we deal with risk depends on how we

define it. This is often a more complicated task than appears.

In pensions, risk is not funding liabilities correctly. Since

pension assets are the primary source of funding liabilities,

risk here can be measured only when you compare the

risk/reward of assets vis-à-vis the liabilities they are fund-

ing. The no-risk asset is the asset that funds the liability with cer-

tainty. A risky asset is one that has much uncertainty about

its risk/reward behavior vis-à-vis the liability it is funding.

The risk-free asset to fund a ten-year fixed liability would

be a ten-year Treasury zero-coupon bond (STRIPS).

This is why FASB ruled that liabilities are to be priced

as high-quality zero-coupon bonds, because they represent

the no-risk portfolio. Assets are to be compared to this zero-

coupon liability portfolio to understand the relative risk and

reward such assets produce in their goal to fund liabilities.

Until the growth rate and the volatility of liabilities

are correctly measured and analyzed, pension risk can

never be understood and managed properly. Since all pen-

sion liabilities are different and unique to each plan, only

a custom liability index could represent the true pension

liability objective. Once a custom liability index is

designed, then and only then can we make the policy

asset allocation decisions, notably, the appropriate depar-

tures from the risk-minimizing portfolio. The risk-min-

imizing asset allocation depends on a custom liability

index for its shape of liabilities.