The purpose of this paper is to provide a summary of the article called “Can We Keep Our Promises?” by Robert D. Arnott, and to help better understand the three key risks facing each investor.
Robert Arnott describes risk and return as “having two sides of the same coin” meaning risk is inseparable from return. Arnott points out the most important risks that are faced by managers of company pension plans: underperforming other corporate pension funds (their peers), losing money (mostly associated with portfolio standard deviation or volatility), and underperforming the values of pension obligations and therefore losing actuarial ground. He defines each of these risks as well as giving a few examples on each one. He quickly jumps into how many tend to focus on standard deviation as the only a single metric calculation, rather than recognizing there are other ways to do so. The author discourages the focus on just one risk, because all are intertwined together and rely on one another.
By focusing on only one risk, for example peer risk, it leaves the company up for even more risk in its assets and pension obligations. Figure 1 illustrates that these risks do indeed rely on one another. When investors try to only minimize one of the risks (small circles) stockholders leave themselves open / exposed to the other two scopes of risk: Beta and Matching (ALM).
Similar to what the article states, we have seen that risk is something that can go wrong, which we are unaware until a crisis happens. Many people tend to ignore the short tails of distribution saying they don't matter because there's a low possibility that it will occur. Think back to one such “perfect storm” that happened back in ...
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...f assets to liabilities is also known as “liability-driven investing” or LDI. LDI is a form of investing in which the main goal is to gain sufficient assets to meet all liabilities, both current and in the future. This type of investing is most prominent with defined-benefit pension plans whose liabilities can often reach into the billions of dollars for the largest of plans. Typical LDI strategies involve hedging the fund's risk to the changes in interest rates and inflation.
Arnott comments on how investors should balance these risks to better understand the health of their company, or at least strive to manage two of the three. As talked about recently in class, I believe all focus should be pointed towards matching assets to liabilities because the safety accomplished through ALM opens up opportunities for increasing the companies net worth. I would
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