A Liability-Relative Drawdown Approach to Pension Asset Liability Management

In recent years, the traditional investment philosophy of defined benefit pension funds has come under pressure. Before the collapse of the tech bubble in 2000 and 2001, pension funds generally invested a large chunk of their port-folio in equities (in some countries as much as 70 per cent) with little regard to the underlying liabilities that they are ultimately funding. When the equity bubble popped and the central banks aggressively cut interest rates, pension funds experienced what has been labeled ‘the perfect pension storm’. Funded ratios of pension funds generally dropped by 40 per cent. Initially, the pension storm led to an awakening in the pension industry. Regulators and accounting boards embraced the practice of marking to market pension liabilities based on the prevailing term structure of interest rates. Some pension funds, particu-larly in Europe, adopted a liability-driven investment approach to replace the traditional asset-only approach. However, the recovery in global stock markets and the low level of interest rates from 2003 to 2006 led to complacency. Many pension funds were reluctant to fully implement a liability-driven approach in the view that interest rates were too low and that it would be too costly to hedge the interest rate risk in liabilities at such levels. Unfortunately, the sub-prime crisis of 2007, that turned into a global financial crisis in 2008, caused another pension storm. Interest rates fell lower still and global equity mar-kets registered one of their worst years on record. US pension funds have seen funded ratios drop on average by about 30 per cent in 2008.