A defined benefit plan has a strategic (i.e., target) asset allocation of 60% equity and 40% debt.

A defined benefit plan has a strategic (i.e., target) asset allocation of 60% equity and 40% debt. This means that the pension should be weighted 60% in equities and 40% in debt instruments. During a certain year, interest rates increase by 300 basis points (3%), impacting the debt portion of the portfolio. The equity portion of the portfolio increases by 4%. Discuss the impact of these changes on the defined benefit pension plan and its asset allocation. Considering the pension funds strategic asset allocation, what actions should the portfolio manager take, if any.

Expert Solution

Since interest rates increased, bond prices would have reduce and hence debt portion would have suffered loss and its weight would have reduces from 40%

Equity portion of portfolio has increased by 4% and hence now carries more than 60% weight in overall portfolio

Action required to be taken by portfolio manager would require REBALANCING of portfolio so that it realigns to the target of 40% in debt and 60% in equities. Hence manager would have to SELL some Equity to bring the equity value and its weight down back to 60%. Also, manager would have to BUY MORE DEBT so that weight increases back to 40%.

jeff jeffy answered 2 years ago

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