One of the biggest challenges confronting the pension and endowment world is managing the gap between the value and behavior of assets and liabilities. This problem is particularly acute concerning liabilities with long maturities (durations).

The dilemma arises from differing interest-rate sensitivity of assets and liabilities; especially if assets and liabilities are comprised of different asset classes (e.g. a pension invests in equities but has liabilities that behave like bonds). When interest rates change, the value of assets and liabilities diverge, creating either a surplus or a shortfall in assets available to fund liabilities.

Using a combination of strips, bills, and bonds, Research Affiliates has refined proprietary investment strategies geared to match asset term with the duration of long maturity liabilities. Matching the interest rate sensitivity of assets with the duration of liabilities insulates pension plans maturity / duration gap risk. Of course, it does not ensure that the plan will have the ability to fund long duration liabilities, since this also depends on managing other risks as well.

Since the greatest interest rate risk lies with the longest maturity liabilities (those with the smallest net present value (NPV), a small amount of money or a small percentage of the total NPV of liabilities can be used to eliminate a proportionately larger percentage of interest rate risk in a portfolio.

• For example, our research on the liabilities held by an actual corporate pension plan revealed that just 10% of the NPV of the plan’s total liabilities could be used to eliminate 25% of the interest rate risk of the plan’s total liabilities. The defeasement strategy of Research Affiliates, therefore, requires a disproportionately small percentage of a pension or endowments assets to eliminate a proportionately larger percentage of liability risk.