Prudential Financial and Asset Liability Management

Fixed Income Securities

Case Discussion

DB vs. DC Pension Plan •

What is a DB Pension plan? Who are the key players in this type of plan?  –

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Employer-sponsored plan Employer manage the funds in order ord er to meet its employee’s employee’s  benefit payouts. It is mandated by the Department of Labor to keep it fully funded.

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DB vs. DC Pension Plan •

Are DB plans still important? What is the difference  between a DB plan and DC plan?  –

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Shifting of corporations from DB to DC plan Still DB plans make up a large portion of total retirement assets in the United States in the form of public pension  plans

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Liability valuation, duration, and major risks •

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PRT transaction requires proper valuation of plan’s liabilities. (Exhibit-4) Main features of payout estimates  –

How far in time the cash flows run

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Their downward trend over time

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Reason: longevity of beneficiaries and interest rate risk.

Prudential will charge premium from ABC (the plan sponsor) Prudential will be responsible for the liability payout  –

Estimation of the PV of liabilities 4

Liability valuation, duration, and major risks •

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PRT transaction requires proper valuation of plan’s liabilities. (Exhibit-4) Discount rate used to value liabilities  –

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Beneficiaries: These are riskless payments so RFR should sho uld  be used  Prudential: pension benefit payments are only guaranteed in the case case that Prundenti Prundential al does not go bankrupt bankrupt •

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Credit rating of Prudential-AA, should be used 

What about ABC’s ABC’s (the (t he employer) ratings Currently Prudential is using corporate blended rate which is higher than the AA-yield curve

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Liability valuation, duration, and major risks •

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PRT transaction requires proper valuation of plan’s liabilities. (Exhibit-4) Duration and interest rate risk   –

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The sensitivity of bond prices to interest rate shifts is affected by the maturities of the cash flows, the coupon payments, and the current yield. 1% up in interest rate PV will go down by 8%

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Liability valuation, duration, and major risks •

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PRT transaction requires proper valuation of plan’s liabilities. (Exhibit-4) Longevity risk   –

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The risk that plan beneficiaries live longer than expected is known as longevity risk. Prudential need to consider the life expectancies of the plan  beneficiaries If life expectancy goes up by 1%, keeping other things constant, what would be the impact on PV of liabilities.

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Asset valuation, duration, and major risks •

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PRT transaction requires proper valuation of plan’s Assets. Investment Risk   –

What happens if the stock market plummets?

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ABC Pension fund: 60% equity, equity, 40% fixed income

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A falling stock market puts the pension plan at risk r isk of becoming underfunded, as value of liabilities will not go down If stock market is falling with the interest rate, Prudential may be at risk  Prudential’s Balance Sheet

Assets (100% stocks)

Liabilities Equity

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Hedging the risks in ALM •

Target: fund’s Target: fund’s value to be sufficient to pay out current and expected future pension benefits.  –

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How should Prudential address investment risk? Is this something that they can hedge?

An all-fixed-income pension fund   –

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What if credit risk goes up In case if stocks fall and interest rates also fall, fixedincome pension fund will increase in value, v alue, similar to the PV of pension liabilities. What about interest rate risk : Duration matching Prudential’s Balance Sheet

(falling interest rate risk) Assets (100% bonds)

Liabilities Equity (unchanged) 9

Hedging the risks in ALM •

Target: fund’s Target: fund’s value to be sufficient to pay out current and expected future pension benefits.  –

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How should Prudential address investment risk? Is this something that they can hedge?

Prudential’s Prudential’s edge in managing longevity risk   –

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Life insurance: increasing longevity-good  Pension plan ?? What about longevity risk : Natural Hedge Prudential’s Balance Sheet

(longevity risk) Assets (equity (equity and and bonds) bonds)

Life insurance Liabilities Pension Liabilities Equity (hedged) 10

Bond portfolio construction •

Risk-adjusted return maximization maximization  –

Should go for maximizing Sharpe ratio? •

Regulatory restrictions

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Hedge can create value

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Can’t take too much risk, if plan become unfunded then Prudential need to arrange equity which may be costly

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Bond portfolio construction •

Cash flow matching and duration matching  –

Should go for cash flow matched portfolio? •

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Should go for duration matched portfolio? •

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Mitigate liquidity risk and reinvestment reinvestment risk  Returns may be low, and will loose liquidity premium

Mitigate interest rate and reinvestment reinvestment risk  But if there is a non-parallel shift in yield curve Slope of the yield curve could change Solution: use key rate duration Any other risk: liquidity risk would be still there

Prudential can holds liquid assets for short term for cash requirement and invest in illiquid assets to earn higher returns •

Duration matching with active liquidity l iquidity management 12

Thank Thank You! ou!

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