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Why conventional bonds may be good for matching pension

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asked Oct 2 in BUS 4027W - Actuarial Risk Management by rohin_jain (790 points)

Question 6.19 (ii) of the Q&A bank ask you to outline suitable matching assets that might be held by the following scheme:

DB pension scheme which offers benefits linked to final salary. Pensions in payment are guaranteed to increase at the lower of price inflation or 5% each year. 

The memo says that conventional bonds may be a good match for current pensioners' benefits (if inflation is greater than 5% p.a.)

The one reason I could see for this is that investors will demand a real yield and hence if inflation is above 5%, then investors will demand yields to be greater than 5% as well. 

So why is this strategy only appropriate when inflation is greater than 5%? Suppose that inflation is 4%, then investors would demand at least 4% and the liability outgo can still be met?


1 Answer

+1 vote
answered Oct 4 by jolegutko (740 points)

Hello!

So, if inflation is greater than 5%, then the pensions will increase at 5% (the lower of inflation and 5%). Then pensions are increasing at a fixed rate, and therefore can be matched with conventional bonds (i.e. cashflows are predictable in nominal terms).

Of course there is the difficulty of knowing what inflation is going to be, but that is too complex for the question, so you can just go with "if inflation is going to be higher than 5%, this is a nominal liability and can be matched using conventional bonds (held to redemption)"

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