How should a defined-benefit pension fund allocate its surplus, and what role does liability-driven investing play?

Defined-benefit pension fund asset allocation centers on the surplus (plan assets minus the present value of liabilities). The two-portfolio approach separates assets into a liability-hedging portfolio (LHP) and a return-seeking portfolio (RSP), with the allocation between them driven by funded status and risk tolerance.\n\nTwo-Portfolio Framework:\n\nTotal Plan Assets = LHP + RSP\n\nThe LHP is designed to move in lockstep with liabilities (duration-matched bonds, inflation-linked bonds). The RSP seeks returns above the liability growth rate (equities, alternatives, real assets).\n\nExample: Deerfield Industries Pension\n\n| Item | Value |\n|---|---|\n| Plan assets | $850 million |\n| PV of liabilities | $720 million |\n| Surplus | $130 million |\n| Funded ratio | 118% |\n| Liability duration | 14.2 years |\n| Active participants | 60%, retirees 40% |\n\nStep 1: Size the LHP\n\nThe LHP must hedge the liability sensitivity to interest rates. Target: match dollar duration of liabilities.\n\nLiability dollar duration: $720M x 14.2 = $10,224M\n\nUsing long-duration bonds (duration 18 years):\nLHP = $10,224M / 18 = $568 million in long bonds\n\nStep 2: Allocate the RSP\n\nRemaining assets: $850M - $568M = $282 million in the return-seeking portfolio\n\nRSP allocation (more aggressive due to healthy surplus):\n- 50% global equities: $141M\n- 25% private equity: $70.5M\n- 15% real assets: $42.3M\n- 10% diversified hedge funds: $28.2M\n\nOverall plan allocation: 67% fixed income (LHP), 33% growth (RSP)\n\nFunded Status and Risk Budget:\n\nThe key relationship: as funded ratio improves, the plan can afford more risk in the RSP (or reduce contributions). Conversely, as funded ratio deteriorates, the RSP should shrink and the LHP should grow.\n\n| Funded Ratio | LHP Allocation | RSP Allocation | Risk Posture |\n|---|---|---|---|\n| < 80% | 90%+ | < 10% | De-risk aggressively |\n| 80-100% | 75-85% | 15-25% | Moderate |\n| 100-120% | 60-70% | 30-40% | Growth-oriented |\n| > 120% | 50-60% | 40-50% | Can harvest surplus |\n\nConstraints on \"Aggressive\" Surplus Investing:\n\n1. Regulatory requirements: ERISA and similar laws impose fiduciary duties; cannot gamble with pension assets regardless of surplus\n2. Accounting volatility: IFRS/GAAP require surplus changes to flow through the income statement or OCI, creating earnings volatility\n3. Contribution reversibility: a surplus can vanish quickly in a market downturn, requiring emergency contributions\n4. Plan demographics: a mature plan with mostly retirees needs more liquidity and shorter duration, limiting RSP aggressiveness\n\nPractice pension allocation problems in our CFA Level III resources.