What are the risks associated with the projectedliabilities of a defined benefit pension plan?

What will be an ideal response?

There are three risks associated with a DB pension fund's projected liabilities: interest-rate risk, inflation risk and longevity risk. See below for more details on these three risks.

The interest-rate risk for the projected liabilities can be quantified in the same way as for assets: computing the duration for the liabilities. We refer to this duration as liability duration. Given the long-term nature of the liabilities, liability duration for DB pension plans can range from 15 to 20 or even more. The significance of a liability duration of this magnitude is important in the formulation of an LDI strategy because, as will be explained, hedging interest-rate risk involves dollar-duration matching of assets and liabilities. To do so, assets with a dollar duration of close to that of the liabilities must be available.

Inflation risk for a DB plan is the risk that the actual rate of inflation experienced over the projection period will be greater than that assumed in projecting liabilities. The sensitivity of the liabilities to inflation risk can be quantified by changing the inflation rate used in projecting liabilities and then revaluing the liabilities.

Longevity risk for a DB pension plan is the risk that actual life expectancy of plan members beyond their retirement date will exceed the life expectancy assumed in projecting the liabilities. As a result, the amount that will actually have to be paid to the plan member will exceed the amount projected. Although we consider longevity risk in the context of a DB pension plan, this risk is faced by life insurance companies in pricing insurance policies and by individuals in planning their retirement. To appreciate the significance of longevity risk, consider the change in the expected life over the past 100+ years and the assumption of a retirement age of 65 . In the United States, the average life expectancy at birth for both sexes according to mortgage tables breaks down as follows: 1950, 68.2 years; 1960, 69.7 years; 1970, 70.8 years; 1980, 73.7 years; 1990, 75.8 years; 2000, 77 years; 2010, 78.7 years. It is expected to be 79.5 by 2020 . Hence, a plan that used an expected life of 73.7 years in 1980 and therefore a payout of 8.7 years after age 65 would have, on average, to make cash payments for five additional years (78.7 years minus 73.7 years) by 2010 . As with inflation risk, the sensitivity to changes in the expected life used in the projection of liabilities and the new valuation for the liabilities based on that expected life can be used to assess the importance of longevity risk.