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IPE special report May 2018

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Study finds salary liability-asset price link

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GLOBAL - There is a "long-run" link between salary-linked liabilities and asset prices, according to a technical paper by an economist at consulting firm Watson Wyatt.

"The relationship between salary-linked liabilities and asset prices is at the heart of the debate about risk management for defined benefit pension funds," says Mirko Cardinale.

Cardinale says that a positive relationship between active liabilities and equity returns will increase the attractiveness of holding equity in a pension fund portfolio. And, given a relationship between wages and assets other than bonds, "a 100% bond portfolio would no longer be a perfect match for active members liabilities".

The 83-page paper, “Cointegration and the Relationship Between Pension Liabilities and Asset Prices", re-examined the evidence of a link between active member liabilities and various asset market returns using cointegration analysis using UK data.

"The main finding is that, while shorter-run correlation evidence is less consistent, there is indeed a long-run link between the evolution of salary-linked liabilities and asset prices." This link is consistent with economic theory, the study finds.

The implications for effective practice in minimum risk asset allocation depend on portfolio rebalancing costs, how much short and medium run asset allocations move around as well as how significant active liabilities are as a proportion of total pension liabilities.

The paper finds that "no asset has historically been a perfect hedge for salary-linked liabilities". The best historical hedge "was a composite portfolio which included besides conventional and index-linked bonds, also domestic and foreign equities and property".

Cardinale says the paper will be of greater importance for relatively young schemes with a high proportion of active members. Their future salary growth cannot be entirely controlled by wage policies at the company level.

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