Fixed Income Securities

Case Discussion
DB vs. DC Pension Plan
• What is a DB Pension plan? Who are the key players
in this type of plan?
– Employer-sponsored plan
– Employer manage the funds in order to meet its employee’s
benefit payouts.
– It is mandated by the Department of Labor to keep it fully
funded.

2
DB vs. DC Pension Plan
• Are DB plans still important? What is the difference
between a DB plan and DC plan?
– Shifting of corporations from DB to DC plan
– Still DB plans make up a large portion of total retirement
assets in the United States in the form of public pension
plans

3
Liability valuation, duration, and major risks
• PRT transaction requires proper valuation of plan’s
liabilities. (Exhibit-4)
• Main features of payout estimates

– How far in time the cash flows run

– Their downward trend over time
– Reason: longevity of beneficiaries and interest rate risk.

• Prudential will charge premium from ABC (the plan

sponsor)
• Prudential will be responsible for the liability payout
– Estimation of the PV of liabilities

4
Liability valuation, duration, and major risks
• PRT transaction requires proper valuation of plan’s
liabilities. (Exhibit-4)
• Discount rate used to value liabilities
– Beneficiaries: These are riskless payments so RFR should
be used
– Prudential: pension benefit payments are only guaranteed
in the case that Prundential does not go bankrupt
• Credit rating of Prudential-AA, should be used
– What about ABC’s (the employer) ratings
– Currently Prudential is using corporate blended rate which
is higher than the AA-yield curve

5
Liability valuation, duration, and major risks
• PRT transaction requires proper valuation of plan’s
liabilities. (Exhibit-4)
• Duration and interest rate risk
– The sensitivity of bond prices to interest rate shifts is affected by the
maturities of the cash flows, the coupon payments, and the current
yield.
– 1% up in interest rate PV will go down by 8%

6
Liability valuation, duration, and major risks
• PRT transaction requires proper valuation of plan’s
liabilities. (Exhibit-4)
• Longevity risk
– The risk that plan beneficiaries live longer than expected is known as
longevity risk.
– Prudential need to consider the life expectancies of the plan
beneficiaries
– If life expectancy goes up by 1%, keeping other things constant, what
would be the impact on PV of liabilities.

7
Asset valuation, duration, and major risks
• PRT transaction requires proper valuation of plan’s
Assets.
• Investment Risk
– What happens if the stock market plummets?
– ABC Pension fund: 60% equity, 40% fixed income
– A falling stock market puts the pension plan at risk of becoming
underfunded, as value of liabilities will not go down
– If stock market is falling with the interest rate, Prudential may be at risk
Prudential’s Balance Sheet
Assets Liabilities
(100% stocks) Equity

8
Hedging the risks in ALM
• Target: fund’s value to be sufficient to pay out current
and expected future pension benefits.
– How should Prudential address investment risk?
– Is this something that they can hedge?
• An all-fixed-income pension fund
– What if credit risk goes up
– In case if stocks fall and interest rates also fall, fixed-
income pension fund will increase in value, similar to the
PV of pension liabilities.
– What about interest rate risk: Duration matching
Prudential’s Balance Sheet
(falling interest rate risk)
Assets Liabilities
(100% bonds) Equity (unchanged)
9
Hedging the risks in ALM
• Target: fund’s value to be sufficient to pay out current
and expected future pension benefits.
– How should Prudential address investment risk?
– Is this something that they can hedge?
• Prudential’s edge in managing longevity risk
– Life insurance: increasing longevity-good
– Pension plan ??
– What about longevity risk: Natural Hedge

Prudential’s Balance Sheet

(longevity risk)
Assets Life insurance Liabilities
(equity and bonds) Pension Liabilities
Equity (hedged)
10
Bond portfolio construction
• Risk-adjusted return maximization
– Should go for maximizing Sharpe ratio?
• Regulatory restrictions
• Hedge can create value
• Can’t take too much risk, if plan become unfunded then Prudential
need to arrange equity which may be costly

11
Bond portfolio construction
• Cash flow matching and duration matching
– Should go for cash flow matched portfolio?
• Mitigate liquidity risk and reinvestment risk
• Returns may be low, and will loose liquidity premium

– Should go for duration matched portfolio?

• Mitigate interest rate and reinvestment risk
• But if there is a non-parallel shift in yield curve
• Slope of the yield curve could change
• Solution: use key rate duration
• Any other risk: liquidity risk would be still there

– Prudential can holds liquid assets for short term for cash
requirement and invest in illiquid assets to earn higher
returns
• Duration matching with active liquidity management

12
Thank You!

13