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1 March 1986 Financial Analysts Journal Volume 42, Issue 2

The Dedicated Bond Portfolio in Pension Funds—Part II: Immunization, Horizon Matching and Contingent Procedures

  1. Martin L. Leibowitz, PhD

Immunization, horizon matching and various “contingent” schemes offer pension plan sponsors and managers an opportunity to minimize risk while retaining some degree of management discretion to pursue lower costs or higher returns.

Immunization calls for the creation of a portfolio of bonds whose value coincides with the present value of a given schedule of liabilities and whose duration, or interest rate sensitivity, is the same as that of the liabilities. Because changes in the portfolio’s reinvestment income and capital gains will always compensate for interest rate changes, the value of the assets will always meet or exceed the value of the liabilities. Immunization offers greater flexibility than simpler forms of dedication, such as cash matching, but it requires portfolio changes over time and is susceptible to certain sequences of market movements.

Horizon matching combines desirable features of both cash matching and immunization. Essentially, horizon matching requires the division of the liability stream into two segments by selection of an appropriate horizon. The portfolio provides full cash matching of the liabilities that occur up to and including the horizon date; beyond that date, the liabilities are covered through a duration-matching discipline based on immunization principles. This allows room for elective management while ensuring fulfillment of the specified payouts over the initial horizon.

By specifying a minimum portfolio return somewhat below the available market rate, the manager can create a “cushion spread” that provides the basis for several contingent schemes. As long as the portfolio retains assets sufficient to meet this target return, it may be actively managed. When adverse market moves threaten this return, the portfolio must be converted into a dedicated mode that will assure the target return. In exchange for accepting a target return below available rates, the manager receives the opportunity to capture profits through active management.

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