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Research

Decomposing funding-ratio risk

August 8, 2017 - Erik Kroon, Anton Wouters and Raul Leote de Carvalho

Providing pension funds with key insights into their liabilities hedge mismatch and other factor exposures

This report, authored by BNP Paribas Asset Management researchers Erik Kroon, Anton Wouters and Raul Leote de Carvalho, was published in the latest edition of the influential Journal of Portfolio Management. It makes an important contribution to the area of risk management by focusing on funding-ratio risk and proposing a framework to yield insights into the main components of funding-ratio risk.

 

Abstract

In recent years, adverse market conditions have demolished the funding status of many defined benefit (DB) pension plans, highlighting the need for better risk management. In this article, the authors propose a novel framework to decompose the risk of DB pension plans which differs from earlier work in two fundamental ways. First, while others focused on surplus risk, the authors give sound reasons to focus on funding ratio risk instead. Second, the authors include a special mismatch factor to measure the sensitivity of the funding ratio to changes in the value of liabilities. They illustrate their framework with a case study based on an actual DB pension fund and decompose its funding ratio risk into mismatch risk and other factor exposures dealing with real interest rates, inflation and economic growth risks.

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