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Portfolio Construction and Analytics by Dessislava A. Pachamanova, Frank J. Fabozzi

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Chapter 15Constructing Liability-Driven Portfolios

The portfolio strategies discussion so far in this book has focused on managing funds relative to a benchmark that is a market index. That is, assets are managed against an index comprised of the same assets. In a liability-driven strategy, the goal is to manage funds to satisfy contractual liabilities.

Asset-liability management is a problem faced primarily by two major groups of institutional investors: life insurance companies and defined benefit pension plans. Life insurance products that include liabilities for the life insurance companies are annuities and guaranteed investment contracts. There are two types of pension plans: defined contribution plans and defined benefit plans. The former require that the plan sponsor contribute a specified amount to a plan participant's pension and once that contribution is made, it is the responsibility of the plan participant to invest the contribution to earn a sufficient return for retirement. That is, once a plan participant retires, no further payments are made by the plan sponsor, and there is no future obligation of the plan sponsor. In contrast, for a defined benefit plan, the plan sponsor agrees to make payments to plan participants when they retire. The annual payment is determined by a formula that is based on the number of years a plan participant was employed and an average of some specified number of years of income prior to retirement.

Although there is a long history ...

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