Inflation indexed benefits

[Alshaikh]

Hi everyone,
I would like to ask about the effect of inflation indexed benefits compared to non inflation indexed benefits on the sponsor’s shortfall risk,

 

[I-will-pass]

Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

 

[Alshaikh]

Thank you

 

[MrSmart]

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

 

[BIL830]

^ I agree with above comment . It impacts an expense on income statement but impact on shortfall risk depends upon the type of bond you are attaching with it .
The reason for inflation indexed Bond to choose is to minimise an impact on shortfall risk.
If there is inflation linked play and you are hedging it with nominal bond then there will be impact on shortfall and if you choose real then I believe there won’t any impact on shortfall

 

[cfacareers]

If it is inflation linked benefits then TIPS would help overcome shortfall risk. However if it is just the impact of inflaton on Pension obligations, then it would lead to a higher actuarial return requirement, and the probability of not achieveing that return. Higher return requirement will result in a greater allocation to equity resulting in exacerbating the shortfall risk due to higher risk.

 

[MissCleo]

For what the OP is internding to ask about the test, yes inflation linked would increase shortfall risk by increasing required return.

 

[BIL830]

How ? The reason for choosing real bonds related to inflation indexed bond is to avoid shortfall risk
if shortfall risk increases with inflation adjusted bonds then there is no need to select real bonds . You are fine with nominal one

 

[cfacareers]

The quesion is whether inflation increases shortfall risk - yes it does as it is linked to pension liability making it worse and increasing return requiremnt. It can be hedged with inflation linked bonds - that is a hedging strategy.

 

[MissCleo]

You can look at the 2012 actual exam AM, with this set up for the plan:
“The company has a mandatory retirement age of xxx and until recently, retirees received inflation-adjusted pension payments.”
The higher returns required are then a reason why they would have a lower risk tolerance.
It later goes on to the same plan without inflation adjusted payments, which increases tolerance.

 

[I-will-pass]

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

 

[MrSmart]

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

 

[Alshaikh]

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Thank you all for your clarification, however, If we made the above assumption that “the assets and liabilities were exactly matched in amounts and factor risks”, then neither plan status, sponsor’s financial position/ profitability nor sponsor/plan common risk factors would affect shortfall risk. But my question was whether a direct relationship between inflation indexed liabilities and shortfall risk exists or not regardless of using nominal or real bonds to mimic those liabilities. This was not elaburated in the book.

 

[I-will-pass]

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Indexing to inflation does not always lead to higher return requirements? I doubt that. Are you making this up? I might habe to get my books or call for the Magician.
I would also counter that in reality you cannot perfectly match most indexed liabilities because the replication of the index is hard (for instance benefits that index with the wage inflation of the workers in the health care sector).
Everything else that you are saying reads like a copy and paste from a text book. Anyone else think that this is incorrect or is this guy right in what he is writing?

 

[MrSmart]

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Indexing to inflation does not always lead to higher return requirements? I doubt that. Are you making this up? I might habe to get my books or call for the Magician.
I would also counter that in reality you cannot perfectly match most indexed liabilities because the replication of the index is hard (for instance benefits that index with the wage inflation of the workers in the health care sector).
Everything else that you are saying reads like a copy and paste from a text book. Anyone else think that this is incorrect or is this guy right in what he is writing?

Let’s substitute fixed benefits (at say, 10%), with an inflation indexed of 8% + inflation.
You could obviously see that the volatility of return is higher, but the return requirement (or the expected return) is not higher, and in fact, known beforehand at each reset (payment) date.

 

[I-will-pass]

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Indexing to inflation does not always lead to higher return requirements? I doubt that. Are you making this up? I might habe to get my books or call for the Magician.
I would also counter that in reality you cannot perfectly match most indexed liabilities because the replication of the index is hard (for instance benefits that index with the wage inflation of the workers in the health care sector).
Everything else that you are saying reads like a copy and paste from a text book. Anyone else think that this is incorrect or is this guy right in what he is writing?

Let’s substitute fixed benefits (at say, 10%), with an inflation indexed of 8% + inflation.
You could obviously see that the volatility of return is higher, but the return requirement (or the expected return) is not higher, and in fact, known beforehand at each reset (payment) date.

look you keep on answering a question that was not asked.
In laymans terms: you pay one of your retirees 100 bucks worth of pension today. And 100 bucks tomorrow. That is non-indexed benefit payment (not obligation). Wage inflation is 10% and you pay 110 bucks than that makes it indexed. Which amount leads to higher liquidity need and hence higher return requirement? I believe this was the question. As the OP has also stated in his direct reply to your comments.

 

[MrSmart]

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Indexing to inflation does not always lead to higher return requirements? I doubt that. Are you making this up? I might habe to get my books or call for the Magician.
I would also counter that in reality you cannot perfectly match most indexed liabilities because the replication of the index is hard (for instance benefits that index with the wage inflation of the workers in the health care sector).
Everything else that you are saying reads like a copy and paste from a text book. Anyone else think that this is incorrect or is this guy right in what he is writing?

Let’s substitute fixed benefits (at say, 10%), with an inflation indexed of 8% + inflation.
You could obviously see that the volatility of return is higher, but the return requirement (or the expected return) is not higher, and in fact, known beforehand at each reset (payment) date.

look you keep on answering a question that was not asked.
In laymans terms: you pay one of your retirees 100 bucks worth of pension today. And 100 bucks tomorrow. That is non-indexed benefit payment (not obligation). Wage inflation is 10% and you pay 110 bucks than that makes it indexed. Which amount leads to higher liquidity need and hence higher return requirement? I believe this was the question. As the OP has also stated in his direct reply to your comments.

Actually, I am answering your, and his question.
Why are you assuming that changing to inflation indexed benefits would be an addition in neutral conditions?

 

[MrSmart]

Alshaikh wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Thank you all for your clarification, however, If we made the above assumption that “the assets and liabilities were exactly matched in amounts and factor risks”, then neither plan status, sponsor’s financial position/ profitability nor sponsor/plan common risk factors would affect shortfall risk. But my question was whether a direct relationship between inflation indexed liabilities and shortfall risk exists or not regardless of using nominal or real bonds to mimic those liabilities. This was not elaburated in the book.

True, which was why I tried to look it up in extracurriculum.
Again, it comes down to “how do you define shortfall risk” in this context. Is it the probability that inflation would come at such a high amount, that the benefit obligations in any given period would jump over a certain threshold? In this case, we would reverse the traditional shortfall risk method and measure the upside risk, to capture the plan’s downside.
Brookings Papers on Economic Activity, Spring 2009
As you can see in this paper, real bonds (or benefits), have lower standard deviation than traditional bonds (fixed benefits), if taken with a liability-only approach, then the shorfall risk in this case would be lower, not higher, all else equal.
Taking an ALM approach, the shortfall risk would ultimatley come down to matching factor risks in dollar terms, and you would better off use a shortfall-beta instead, but I’m not well read on this matter.
Using a simpler approach, which I think the one CFAI is using when referring to SFR in the context of institutional portfolio management, it would be something along the lines of:
Z = (E(RA) - E(RL)) / (σA + σL)
I have no idea if this is a correct measure, but I’m thinking out loud.

 

[I-will-pass]

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Indexing to inflation does not always lead to higher return requirements? I doubt that. Are you making this up? I might habe to get my books or call for the Magician.
I would also counter that in reality you cannot perfectly match most indexed liabilities because the replication of the index is hard (for instance benefits that index with the wage inflation of the workers in the health care sector).
Everything else that you are saying reads like a copy and paste from a text book. Anyone else think that this is incorrect or is this guy right in what he is writing?

Let’s substitute fixed benefits (at say, 10%), with an inflation indexed of 8% + inflation.
You could obviously see that the volatility of return is higher, but the return requirement (or the expected return) is not higher, and in fact, known beforehand at each reset (payment) date.

look you keep on answering a question that was not asked.
In laymans terms: you pay one of your retirees 100 bucks worth of pension today. And 100 bucks tomorrow. That is non-indexed benefit payment (not obligation). Wage inflation is 10% and you pay 110 bucks than that makes it indexed. Which amount leads to higher liquidity need and hence higher return requirement? I believe this was the question. As the OP has also stated in his direct reply to your comments.

Actually, I am answering your, and his question.
Why are you assuming that changing to inflation indexed benefits would be an addition in neutral conditions?

i dont even know what you are asking. I do know that your answers sound pretty far fetched to me and I am probably not at the same intellectual level or just not interested in wasting any more time as its pointless. Hence 1 issue, multiple opinions. That happens in real life, or should I say under non-neutral conditions. Cheers to Egypt.

 

[vgmalu]

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:

MrSmart wrote:

I-will-pass wrote:
Inflation indexed means higher contributions hence higher expenses on the income statement as well as higher shortfall risk.
Was this what you wanted to know? Feels like some of the questions on the exam…if you know what I mean! No offense.

That’s not nessecarily true. I remember trying to find an answer some time ago, but never did.
First, you must define shortfall risk in the context of inflation indexed benefits before trying to come up with a solution.

that doesnt make any sense to me. Please explain. Thanks.

Indexing inflation does not always lead to higher expenses, or higher return requirements.
Measuring shortfall risk can be done with a liability only approach, or an asset-liability portfolio approach.
If the assets and liabilities are exactly matched in amounts and factor risks, then your shortfall risk is zero. The return requirement in this case would reset at each period, simillar to a floating bond. Then you would calculate a shortfall risk based on this new return requirement, using the equity’s standard deviation as your measure of risk.

Indexing to inflation does not always lead to higher return requirements? I doubt that. Are you making this up? I might habe to get my books or call for the Magician.
I would also counter that in reality you cannot perfectly match most indexed liabilities because the replication of the index is hard (for instance benefits that index with the wage inflation of the workers in the health care sector).
Everything else that you are saying reads like a copy and paste from a text book. Anyone else think that this is incorrect or is this guy right in what he is writing?

Let’s substitute fixed benefits (at say, 10%), with an inflation indexed of 8% + inflation.
You could obviously see that the volatility of return is higher, but the return requirement (or the expected return) is not higher, and in fact, known beforehand at each reset (payment) date.

look you keep on answering a question that was not asked.
In laymans terms: you pay one of your retirees 100 bucks worth of pension today. And 100 bucks tomorrow. That is non-indexed benefit payment (not obligation). Wage inflation is 10% and you pay 110 bucks than that makes it indexed. Which amount leads to higher liquidity need and hence higher return requirement? I believe this was the question. As the OP has also stated in his direct reply to your comments.

Actually, I am answering your, and his question.
Why are you assuming that changing to inflation indexed benefits would be an addition in neutral conditions?

i dont even know what you are asking. I do know that your answers sound pretty far fetched to me and I am probably not at the same intellectual level or just not interested in wasting any more time as its pointless. Hence 1 issue, multiple opinions. That happens in real life, or should I say under non-neutral conditions. Cheers to Egypt.

In layman terms, what they are discussing is whether being Inflation Indexed always leads to only unfavorable circumstances for a firm and leads to increase in shortfall risk at all times?. I think generally if we are in an inflationary environment always, this should be the case (increased shortfall risk)
Now the question is what do you mean by Neutral condition, if we are going to pay all retirees (accrued benefits) inflation indexed, then in an deflationary environment(throughout) , you actually end up paying lesser (leads to lower shortfall risk)
I doubt whether it is worthwhile to make scenarios and get into so much detail.