A pension plan sponsor may take either a “legal termination” or an “economic going-concern” view of its pension liabilities. Both views are valid, but the two have significantly different implications for the sponsor’s balance sheet risk and for the appropriate asset-mix policy for a defined-benefit pension plan.
In the legal termination context, the goal of the pension fund is to ensure that enough money is available to pay the accrued pension debt, in nominal terms. By matching asset and liability durations—that is, by holding a long-duration, all-bond portfolio—the sponsor can minimize the risk that plan assets will fall short of the termination liability. But actual plan sponsor behavior suggests that most sponsors take a going-concern view of pension liabilities. In this context, the relevant risk is that actual returns will not match anticipated returns, with excesses or shortfalls having significant impact on the sponsor’s contribution-rate risk.
When it is economic going-concern liabilities that are being invested against, an all-bond portfolio makes little sense; although it may preserve portfolio wealth in some economic scenarios (such as the 1929–32 deflation), such a policy will seriously erode the real value of pension assets in other periods (e.g., the 1978–81 inflation). The appropriate asset-mix policy for minimizing risk over the long term calls for a 40 to 70 per cent investment in equities and other risky assets.
