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IAI Actuarial Core Principles · Business Management · Issues and challenges in each main practice area

A retirement-benefit fund's liabilities are linked to future salary growth and inflation. The actuary notes that holding only fixed-coupon government bonds leaves the fund exposed. Which asset class is most naturally suited to hedge the inflation-linked part of these liabilities?

Inflation-indexed bonds are most suitable because their coupons and principal rise with inflation, matching liabilities that grow with prices. Fixed-rate deposits, zero-coupon bonds, cash and fixed-dividend preference shares give nominal payments that lose real value if inflation is higher than expected.

  1. AFixed-rate deposits with banks
  2. BZero-coupon bonds of long term
  3. CCash held in savings accounts
  4. DInflation-indexed bondsCorrect
  5. Preference shares paying fixed dividends

Explanation

Liabilities that rise with inflation are best matched with assets whose cashflows also rise with inflation, such as inflation-indexed bonds. Fixed-rate instruments lose real value when inflation exceeds expectations.

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