Pension Funds L3

Section: Pension Fund Portfolio Management Estimated study time: 45 minutes Content: Defined benefit (DB) pension funds are among the most important institutional investors and are heavily tested at CFA Level 3. A DB pension fund promises a defined benefit to plan participants upon retirement, requiring the fund to accumulate sufficient assets to meet those future obligations. The pension manager's primary objective is meeting the liability — not maximizing absolute returns. This makes pension fund management fundamentally different from managing an endowment or a sovereign wealth fund. The funded status of a pension plan is the ratio of assets to the present value of liabilities (projected benefit obligation, or PBO). A funded ratio above 100% is overfunded; below 100% is underfunded. The funded ratio drives investment strategy: underfunded plans must take more risk to close the funding gap (higher RSP allocation); well-funded plans should de-risk (shift to LMP). The sponsor's risk tolerance for funded status volatility depends on: the plan's relative size compared to the sponsoring company's market capitalization (large plans relative to sponsor are "corporate risk"), the correlation of plan performance with the sponsor's business cycle, and the sponsor's financial health and credit quality. Duration management is central to DB pension management. The PBO has a very long duration — sometimes 12-18 years for mature plans — because it represents distant future cash flows discounted at current rates. A plan whose asset duration is much shorter than liability duration will experience funded status volatility when interest rates move. Every drop in rates increases the PBO by more than it increases asset values, worsening funding. LDI strategies address this by extending asset duration toward liability duration. The Investment Policy Statement…