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DISCUSSION PAPER PI-0709

The Term Structure of Funding Spreads

Joachim Inkmann and David Blake

Defined benefit pension liabilities are usually computed by discounting promised
future pen-sion payments using the yields on either risk-free or AA-rated bonds.
We argue that a pension plan in financial distress should use discount rates that
reflect the inherent funding risk. We propose a new valuation approach that
utilizes the term structure of funding-risk-adjusted dis-count rates. These discount
rates depend on the current asset allocation of the pension plan which affects
expected future funding ratios. We show that an optimal asset allocation which
accounts for this dependency varies in a highly nonlinear way with the initial
funding ratio of the pension plan. In particular, the optimal allocation to stocks is
higher than conventionally determined when the level of underfunding is severe,
but lower when the level of underfund-ing is only moderate.

Key words: term structure, funding risk, funding spread, asset-liability management,
pen-sion plan