Handbook of Finance: Investment Management and Financial Management

Chapter 47. Creating an Optimal Portfolio to Fund Pension Liabilities

PAUL ROSS

Investment Associate, Bridgewater Associates

DAN BERNSTEIN

Director, Research, Bridgewater Associates

NIALL FERGUSON

Manager of Client Service Analytics, Bridgewater Associates

RAY DALIO

President and Chief Investment Officer, Bridgewater Associates

Abstract: The asset and liability mix of typical pension plans is poised to generate no excess return on assets above the return on their liabilities over the long-term. Further, it is likely to produce a high degree of volatility in funding status, which implies large sporadic contributions or reductions in benefits in the future. By immunizing liabilities, the typical plan could increase its total plan returns (increase its return above the return on liabilities) and reduce risk. Diversifying exposures in an excess return portfolio can further increase returns (above liabilities) per unit risk. This benefit of diversification (that is, more consistent returns) can either be used to increase returns at the same level of risk or decrease risk at the same level of targeted returns (or some combination of the two). The level of excess return for each plan should match the plan's particular risk-preferences and goals. Similarly, just as a fund can dial up or dial down the risk (and return) of its excess return portfolio, plans can similarly dial up or dial down their immunizing portfolio (that is, a fund could immunize any amount of their liability) and realize part ...