Under example 4 - external constraints and asset allocation, the insurance company plans would like to limit risk to the plan’s funded status. The pension assets are 95% invested in high-quality intermediate duration bonds and 5% in global equities. The duration of pension liabilities is approximately 25 years. (Institute 341)
Institute, CFA. 2019 CFA Program Curriculum Level III Volume 3. CFA Institute, 5/2018. VitalBook file.
One of the proposals suggests retaining the same asset allocation but it was criticized that given the intermediate duration bond allocation, the proposal fails to consider the mismatch between pension assets and liabilities and risks a reduction in the funded status and increased contributions if bond yields decline. (If yields decline across the curve, the shorter duration bond portfolio will fail to hedge the increase in liabilities.). It was also criticized that the proposal does not reduce balance sheet and surplus risk relative to the pension liabilities.
Why is that so? I thought if the liabilities are now immunized, investing in a different duration may introduce a basis mismatch?
Why do you think the liabilities are immunized? Based on what you posted, the text specifically suggests there is a mismatch and therefore it is not immunized.
“fails to consider the mismatch between pension assets and liabilities”
There is nothing in the passage that suggests that the funds are not immunized or mismatched either. The passage seems to suggest that everything is well. I would have missed the part on investing in longer duration bonds to minimize balance sheet and surplus risk.
The assets are invested in intermediate term bonds (5-10yrs) while the duration of liabilities is 25 years… I see a mismatch, bad when interest rates increase!