A defined benefit pension plan is effectively an operating division of the sponsor. Thus, when evaluating risk and making asset allocation decisions, it is more appropriate to focus on the plan’s net worth—the difference between its assets and liabilities—than on its assets only. This requires the development of probability distributions for both assets and liabilities.

Liability modeling is still in its infancy, and different models lead to radically different notions of the riskiness of liabilities. In particular, the way in which a plan’s actuarial assumption for inflation/salary growth is modeled can have an enormous impact on the relative attractiveness of stocks and long bonds.

Some simplified approaches to liability modeling focus on fixed dollar liabilities (the Accumulated Benefit Obligation) or on the responsiveness of inflation-sensitive liabilities (such as the Projected Benefit Obligation) to changes in discount rate assumptions. Under these approaches, liabilities behave like bonds, and long bonds constitute a large proportion of efficient pension portfolios. A model that assumes volatility in real rates, however, shows liabilities to be extremely volatile and results in efficient portfolios with a significant proportion of stocks.