For an investor with a primary objective of meeting future liabilities, it’s useful to build a framework for investing assets to meet those future liabilities. The first step in exploring such a framework requires an understanding of the nature of the liabilities and what economic factors can be deemed to impact the future liability cash flows.

In order to make the best asset allocation decisions, it helps to understand the degree to which liabilities are dependent on fixed payments and inflation. For example, a plan sponsor with primarily indexed pensioners would view the underlying pension payment as a fixed payment. Over time, however, the pension payment would be subject to a cost-of-living adjustment, introducing an inflation component into the equation.

A second step in this asset allocation process would be to similarly map the assets in the investment portfolio into economic risk factors of fixed payments and inflation. A third factor can be introduced for assets called return driven, which exhibits low correlation to liabilities but has attractive risk-return characteristics.

Most asset classes don’t fit solely into one specific area and would therefore include a mix of these factors. In this framework, allocations to each asset class involve understanding how much risk the fund can afford to take and, therefore, the extent to which the primary risk factor exposures must be hedged. This requires a greater comprehension of the risk factors and how they affect both assets and liabilities.

The first economic risk factor to explore is fixed payments, which can be extremely useful for hedging against defined future liabilities. Common examples of groups whose liabilities have fixed payment characteristics include non-indexed pensioners and active employees with career average plan liability formulas (i.e., liabilities that do not depend on inflation or salary increases).

Both of these groups receive a definite pension upon retirement that’s not subject to future variations. Assets with fixed payment characteristics, such as fixed income or commercial mortgages, can provide a good hedge since their cash flow streams are predefined. They can also be mapped out with some degree of certainty and matched to pension obligations. The only uncertain variable remaining is mortality, but as long as the pensioner population is diverse enough that it follows mortality table projections, payments over the life of the plan should be relatively predictable.

The next economic risk factor is inflation, which can be used to hedge other factors, such as cost-of-living adjustments. Indexed pensioners and active employees with final average plan liability formulas (where salaries are often highly tied to inflation) are types of liabilities that have inflation characteristics. While these liabilities usually have a large fixed payment component, the adjustments due to inflation can be significant over the course of a typical pensioner’s retirement.

Real return bonds are an example of an asset with inflation-hedging characteristics, since the rate of return is adjusted to keep pace with inflation. Real estate and infrastructure investments also exhibit inflation-hedging characteristics to some degree. Both the underlying assets and income streams of real estate and infrastructure are usually positively correlated with inflation, providing at least a partial hedge over time. However, since the income streams for both asset classes are often contracted for extended periods (five or more years), there will often exist a lag between when inflation occurs and when it’s reflected in the income streams.

The final economic risk factor, return driven, is the most volatile of the three and has no liability-hedging characteristics. However, return-driven assets still play an important role in portfolios, either because of their high expected returns relative to risk or anticipated low correlation with other asset classes.

Real estate and infrastructure both exhibit return-driven characteristics, since their asset values can be highly influenced by the supply and demand in the market. Equities are also a prime example of an asset class with return-driven characteristics: They can be extremely volatile over the short term, but can offer compelling returns over a longer time period. Since return-driven assets have no liability-hedging characteristics, their use is a function of a plan sponsor’s risk tolerance for a mismatch between assets and liabilities.

In reality, investors can choose to map economic risk factors onto asset classes and liabilities using historical relationships or based on anticipated future relationships. It’s also helpful to reiterate that elements of all three risk factors may be present in a single asset class, the issue being to what degree this is the case.

For example, similar to real estate and infrastructure, a dividend-sensitive equity portfolio may have the following characteristics: it may have a small fixed payments component represented by the dividend stream, and a dividend stream that increases over time as a company’s earnings increase may have inflation exposure. The underlying equities are expected to have high volatility but with corresponding higher expected returns (return driven), which make the heightened volatility acceptable. The degree to which each risk factor can be attributed to the asset class in question depends on the plan sponsor’s chosen methodology.

When plan sponsors develop an understanding of the underlying factors that impact both assets and liabilities, it can provide useful insights into asset allocation decisions. The mapping of asset allocation depends on not only on the factors but also the overall risk tolerance of the plan sponsor. The plan sponsor’s risk tolerance will ultimately determine the allocation to the return-driven factor and the precision with which the fixed payment and inflation factors are hedged.

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