Liability-Driven and Index-Based Strategies

Correct Answer: Increase the allocation to fixed income securities with durations that closely match the liabilities, while maintaining a smaller allocation to equities for potential growth.

The most appropriate approach for the pension plan's objectives is to increase the allocation to fixed income securities with durations that closely match the liabilities, while maintaining a smaller allocation to equities for potential growth. This strategy, known as liability-driven investing (LDI), helps minimize funding ratio volatility by aligning the duration of the assets with the duration of the liabilities. By doing so, the plan's assets and liabilities will respond similarly to changes in interest rates, reducing the risk of underfunding. Maintaining a smaller allocation to equities provides the potential for higher returns, which can help improve the plan's funding status over the long term. Shifting the entire portfolio to fixed income securities would eliminate the potential for higher returns from equities, which could hinder the plan's ability to meet its long-term obligations. Using interest rate derivatives to hedge the duration gap can be an effective strategy, but it may introduce additional complexity and counterparty risk compared to directly adjusting the asset allocation.

Correct Answer: Gradually increase the allocation to fixed income securities while extending the duration of the fixed income portfolio to better match the liabilities, and consider incorporating derivative instruments to manage interest rate risk and maintain some equity exposure for potential growth.

The most appropriate approach given the plan's objectives and current situation is to gradually increase the allocation to fixed income securities while extending the duration of the fixed income portfolio to better match the liabilities. This strategy, known as liability-driven investing (LDI), aims to align the assets with the liabilities to manage interest rate risk and reduce the volatility of the plan's funded status. By extending the duration of the fixed income portfolio, the sensitivity of the assets to interest rate changes will more closely match that of the liabilities, minimizing the impact of interest rate fluctuations on the funded status. Incorporating derivative instruments can further help manage interest rate risk and maintain some equity exposure for potential growth. Maintaining the current 70% equity allocation is not advisable, as it exposes the plan to significant market volatility and does not address the interest rate risk concern. While equities have historically outperformed fixed income over the long term, they do not provide a direct hedge against the plan's liabilities. Reducing the equity allocation to 50% and increasing the fixed income allocation to 50% without extending the duration of the fixed income portfolio does not adequately address the interest rate risk issue. The duration mismatch between the assets and liabilities would still persist, leaving the plan vulnerable to interest rate changes.

Correct Answer: Increase the allocation to long-duration fixed income securities to better match the liabilities, while using index-based strategies for the equity portion to maintain diversification and manage risk.

The most appropriate strategy for the insurance company's objectives is to increase the allocation to long-duration fixed income securities to better match the liabilities, while using index-based strategies for the equity portion to maintain diversification and manage risk. This strategy aligns with the company's goal of reducing interest rate risk by narrowing the duration gap between assets and liabilities through the use of long-duration fixed income securities. By matching the duration of assets more closely to the long-term liabilities, the company can mitigate the impact of interest rate fluctuations on its financial position. Furthermore, employing index-based strategies for the equity portion of the portfolio helps maintain diversification and manage risk, which is consistent with the investment policy statement's emphasis on a well-diversified portfolio. Index-based strategies provide broad market exposure and are cost-effective compared to actively managed strategies. The other two options are less suitable because: - Shifting the entire portfolio to a passive index-based approach equally weighted between fixed income and equity indices may not adequately address the duration gap and interest rate risk, which is a primary concern for the insurance company. - Maintaining the current 60/40 asset allocation with actively managed strategies that aim to outperform benchmarks and generate alpha may not prioritize the reduction of interest rate risk and could result in higher costs and less diversification compared to index-based strategies.