Correlation of sponsor operating results with pension asset returns

CFA Level III Portfolio Management
#1

I dont get this point. can anybody explain this?

#2

Little more detail?

#3

You want the operating result to have as low as possible correlation with pension result. If pension return is low, more than likely, company need to contribut to make up the gap, of course if operating result is good, company can/and has the ability to make pension contributions. So you want: Pension return is low (need money), however, company is doing well (have money to contribute)===>>negative correlation You don’t want: pension return is low (need money); however, company is doing poorly (have no money to contribute)===>> positive correlation. Does this help??

#4

Just to add to what ws said … Pension asset returns need to have low correlation with sponsoring firm operating results but high correlation with pension liability changes.

#5

Yup. Gorrit. Thanks.

#6

Why have high correlation with liabilites?

#7

Because pension plans (DBs) are run by LDI - liability driven investing (subset of ALM).

You certainly don’t want your assets returns to be low in the times of low sponsor financial performance, and you certainly want to have sufficient assets to cover liabilities.

Otherwise, nor would sponsor be able to fund your shortfalls in times of underperformance, nor would you be able to pay out benefits to retirees (at least not to all).

#8

I understand about low correlation of plan assets with operating assets of sponsor…But high correlation of plan assets with operating liabilities, I dont?

#9

You want your plan assets to perform higher as the liabilities increase also. It’s because a company generally has to “step in” and fund any “liability shortfalls” not covered by the plan’s assets and returns on those assets.

So if the sponsor’s liabilities are increasing and it has less ability to fund the pension plan or fill any plan funding gaps, you want the plan’s returns to be increasing too - so that there is less need for the sponsor to fill any gaps in the first place.

Lower “ability” of a sponsor to fund a plan shortfall should ideally be matched with lower “need” to fund a shortfall. Does this help?

Cheers - good luck - you got this :+1:

#10

I believe you are mistaking liabilities of a Plan with operating liabilities of the Sponsor.

You want high correlation with Plan’s liabilities not Sponsor’s liabilities.

And you want low correlation with Sponsor’s operating results because of the reason’s mentioned by Grey and myself.

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#11

This is what the text says-it is desirable for plan assets to have low (high) correlations with the sponsor’s operating assets (liabilities).

#12

It is as I tried to explain above buddy. Does it make sense? In theory you have 2 sources of liability funding, for a pension plan:

  1. Plan assets and returns on those assets (ideally this covers most or all of plan liabilities)
  2. Contributions from the sponsor company (whenever there are plan shortfalls etc.)

As a sponsor company’s operating performance weakens, (fewer operating assets and greater operating liabilities, and weaker overall financial ability to make shortfall funding contributions) you want the plan’s performance to step in and cover the slack. Because the company is in a lesser position to do that due to having weaker financial ability at this time.

So as cash situation of the company gets worse, you want the plan performance to get better. As the operating liabilities increase, you want the plan performance to increase. Positive correlation in other words.

Likewise - as has been stated by others in a thoughtful and precise manner above - you want your plan returns not to be correlated to your sponsor’s own financial performance. Because this is the essence of risk diversification. If the plan is too correlated to the sponsor’s own financial picture, there is no risk diversification. When the plan (and sponsor) are performing badly at the same time due to cyclical industry patterns etc., it’s a double whammy for funding the plan liabilities because your plan is doing worse and your sponsor has lesser ability to fund the shortfalls and step in to cover things.

Cheers - good luck - you got this :+1:

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#13

Thanks you so very much for this detailed explanation…u rock…

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