The significance of liabilities

Although it's easy to measure the worth of most assets, which can be assigned an accurate value today, the principal purpose of pension plan assets is to fund liabilities. Therefore, measuring whether assets are sufficient to cover the liabilities is an important and challenging task for the CAAT Plan.

In the past, the Plan regularly reported the asset size of the pension fund on a monthly basis. These figures, although interesting, merely showed a snapshot of the fund size as of a month-end date. They are not really a practical indicator of the viability of a long-term entity like a pension fund. Likewise, while the market benchmarks the Plan uses to measure the performance of the portfolio also provide worthwhile information, benchmarks cannot determine whether the portfolio is returning enough to pay the promised pension benefits in the future.

In order to better gauge the ability of the fund to pay the promised pensions, liabilities must also be taken into consideration.

What are liabilities?

The promised pension payments must come from the fund, and these pension payments are known as liabilities.

The value of these liabilities is sensitive to changes in interest rates and the inflation rate. Low interest rates increase the cost of liabilities because more money is needed today to cover the cost of tomorrow's pensions. Since it's not possible to predict how interest rates will behave in the future, it is difficult to estimate the cost of funding future liabilities.

Additional factors, such as increased membership, decreased retirement ages and demographic shifts add to the uncertainty. For example, our increasing longevity, although good news, means that pensions are paid out for a longer period of time, adding to the Plan's liabilities.

Liability driven investing

Liability driven investing (LDI) has become an increasingly important consideration for pension plans around the world. LDI can be thought of as investing in such a manner that a part of the fund will behave in the same way as the liabilities. This part of the fund will grow when interest rates go down, and vice versa.

Part of the Plan's investment strategy involves exposure to "Liability Hedging Investments". This includes long-term assets such as nominal and inflation-linked bonds, infrastructure and real estate. These investments are used to hedge the inflation and interest rate sensitivity of our liabilities. The other part of the fund is invested in "Return Enhancing Investments", which will, it is hoped, grow faster than the liabilities over the long term.

Measuring liabilities

Overall, measuring of liabilities as well as assets, and taking their behaviour into account when determining the asset mix policy, is the most effective way to make sure the Plan remains on track to deliver the pension promise.

• The Plan, along with our actuary and risk management consultant, conducts long-term asset-liability studies and risk assessment which, in addition to determining the appropriate asset allocation strategy, identify the risk profile of the Plan's liabilities.
• The ongoing measurement of our liabilities is a key component of the actuarial valuations that are performed annually.
• Monitoring of investment returns and how they relate to changes in the Plan's liabilities is also done on a frequent basis.
• The Plan is also actively engaged in risk budgeting, which is closely related to the evaluation of liabilities.

It is often said that asset allocation is the key factor in creating a successful investment portfolio for a pension plan. And liabilities - the pension payments that will ultimately be made to Members - are the most important driver of what is appropriate for asset allocation.