When would a contingent immunization and duration matching strategies be suitable for a pension plan?
A pension plan is likely to never use contingent immunization because that would require the fund being over funded - which, basically none of them actually are. Staying underfunded is a great way to borrow at low rates.
In CAFI AM Mock in the “Pavonia Case Scenario” there is a case of two fixed-income portfolios of two new defined benefit plan clients. One of the question states;
Q. Which of the following three strategies is least likely appropriate for the plans in Exhibit 2?
- Duration matching
- Cash flow matching
- Contingent immunization
Solution
B is correct. Cash flow matching is least appropriate for both plans. In both the Lawson and Wharton plans, participants are entitled to receive a monthly benefit. Cash flow matching entails building a dedicated portfolio of zero-coupon or fixed-income bonds to ensure there are sufficient cash inflows to pay the scheduled cash outflows. However, such a strategy is impractical and can lead to large cash flow holdings between payment dates, resulting in reinvestment risk and forgone returns on cash holdings.
Can some one help on this?
Based on this question, both plans have a surplus so CI is possible.
Surplus is small and plan managers may not wanna risk active mgmt of surplus, so they can even choose duration matching.
Now these pension liabs are quite hard to model out. Eg - next year if the firm sees a sudden uncrease in employment and if those guys subscribe for the DB plan, that’s an additional liab on the notch. CF matching is based on having cash flows coming in from bonds to match liab payment which may not be possible here as DB plan liabs may be hard to model.
Duration matching is the most correct, contingent immunization is the next most correct since it involves moving to a duration-matched liability relative investing strategy upon the surplus going to zero. Therefore cash flow matching is the least correct for the reasons stated in the answer.
Think if you were managing a pension plan - it would be awfully hard to construct a portfolio where your cash inflows exactly matched your cash outflows month to month.
Just for clarity, since pension is a type 4 lia, we really dont know the duration or the cashflow with certainty. But we still use these method to hedge out against a potential liability. And out of these all methods, cashflow is the the least ideal one because its too expensive?