Pension Liabilities and Risk Parity

Abstract

With dismal equity return and falling interest rates of the last decade, pension funds in general are severely underfunded. Going forward, reducing the funding gap remains a daunting challenge for plan sponsors.With the current environment of low interest rates, absent the unpalatable options of increasing contributions or reducing benefits, many are counting on a continuing booming equity market as the only chance to get out of the current predicament. However, the asset–liability mismatch remains highly risky when pension investments rely heavily on equity. Risk parity as a strategy that maximizes risk-adjusted return with balanced risk allocation can provide an alternative solution in helping plan sponsors manage asset–liability risk and the de-risking process as well as closing funding gaps gradually over time. Furthermore, the application of risk parity is different for public and corporation pensions because their liability “benchmarks” are different.