How should a pension plan set asset allocation given its liabilities?

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AcadiFi · Accepted Answer

LDI allocation depends on funded status, sponsor risk tolerance, and glide-path policy. A well-funded plan (>105%) typically runs 70-85% liability-hedging and 15-30% return-seeking. An underfunded plan (85%) needs more return-seeking to close the gap. ```mermaid flowchart LR A[Funded Ratio] --> B{Trigger?} B -->|Yes 95%| C[De-risk
60/40 LDI/RS] B -->|Yes 105%| D[De-risk
80/20 LDI/RS] B -->|No 85%| E[Hold
40/60 LDI/RS] ``` The liability-hedging portfolio (LDI bucket) uses long Treasuries, long credit, STRIPS, and derivative overlays (interest rate swaps, swaptions) to match PBO duration, typically 12-14 years. A 'completion manager' trims residual curve and credit mismatches. The return-seeking portfolio (RS bucket) holds public equity, private equity, real assets, and hedge funds to drive surplus growth. Glide paths automatically shift allocation as funded ratio improves — Willowbrook might target +5% LDI for each 5-point improvement above 95%. Key implementation concerns: (1) hedge ratio on rates separate from credit spreads (liabilities discount at corporate AA, so holding Treasuries leaves unhedged spread risk); (2) completion fund manages convexity gaps; (3) collateral management for swap positions; (4) derivative regulatory treatment under uncleared margin rules. Performance measurement compares to a liability benchmark, not a market index. The end-state for many plans is either full buy-out with an insurer or a hibernation strategy holding matched assets until final participant.

How should a pension plan set asset allocation given its liabilities?

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