The liability benchmark
LET’S ASK A CRITICAL question: what really drives the long-term performance outcomes of retirement funds? What the academics will tell you is that, by and large, it is the strategic asset allocation decision and its commensurate benchmark that can account for as much as 90% of variability in performance. (Note that the answer is not manager’s stock selection, sector rotation or market timing.) But, academic debate aside, if the strategic benchmark does have such an overwhelming influence on outcomes, shouldn’t it be the most important discussion?
Let’s take as given that the answer is affirmative.
The entire retirement fund industry exists to facilitate the process whereby individuals (or groups of individuals) save regular contributions throughout their working lives to secure an income from their savings after retirement. There are two sides to this liability. From the fund’s perspective, its obligation (liability) would be defined as providing the benefit promised to the member. From the members’ perspective, the liability is their spending requirement after retirement ‒ ie, food, shelter, medical costs, transport, leisure, etc.
Loosely translated this sets the obligation as a set of future expected cash flows to the member. By defining the problems in these terms, it should be possible to place a market value on those cash flows by discounting them using a suitable yield curve. That way of valuing cash flows is used every day in the pricing of bonds and life annuities, as well as in the valuation of defined benefit (DB) retirement liabilities worldwide.
One then addresses the investment management of this obligation by simply building a matching portfolio that meets the monthly cash flow reguirements.
The liability benchmark
The liability benchmark is very much related to this concept of a matching portfolio. In fact, if perfect cash flow matching is possible the liability benchmark is nothing more than the index of the performance of the matching portfolio over time. However, in practice perfect matching isn’t always possible, mainly due to a lack of very long dated instruments and you can expect a matching portfolio to deviate slightly from the liability benchmark.
The best way to explain this concept is to look at a worked example. ABC Pension Fund is a closed DB fund with 1 000 pensioners. The rules of the fund guarantee an annual pension increase in line with consumer price inflation. By applying an appropriate mortality table to the actual fund membership you can derive a set of expected future cash flows for the fund. A current value can then be calculated by valuing the cash flows using an appropriate real yield curve. (That’s the same as constructing a matching portfolio of assets and then taking the market value of that portfolio. There may be a slight difference when the liabilities extend further than the available assets, in which case perfect matching isn’t possible.)
The liability benchmark is then constructed over time by valuing the expected cash flows on a regular basis ‒ say, every month using the latest yield curve.
The main use of the liability benchmark is, of course, to keep track of the change in the value of the liabilities over time, and by comparing it with the change in the value of the assets you can easily keep track of the funding level (the ability of the fund to meet future liability cash flows).
As the liability index also represents the liability-matching portfolio it can be used to determine the total risk of the fund’s investment strategy in relation to its liabilities. That’s much more informative than the usual measure of active risk compared to a benchmark that has no relation to the liabilities. Here we have three different investment strategies relative to the liability benchmark. (Balanced, CPI+5% and cash). Seegraphs1and2).
Absolute volatility (in asset-only space)
In absolute terms the liability benchmark can be quite volatile, as it’s basically a type of long duration inflation-linked bond portfolio in this example. In absolute terms, cash is the “least risk” portfolio. (See graph 3)
Even though the balanced portfolio outperformed the liabilities for most of the period it’s clear there’s considerable risk in that strategy relative to its liabilities. (See graph 4) Relative volatility (in asset-liability space) If we now consider the performance