Learning Outcomes
After reading this article, you will be able to define and measure funding ratio risk in liability-driven and goal-based approaches, explain the mechanics and rationale of asset-liability management for institutional and individual portfolios, distinguish the role of funding ratio glidepaths, and critically apply these concepts to exam-style scenarios. You will also learn to interpret how portfolio risk changes as funding ratios and objectives shift over time.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the practical application of liability-driven and goal-based investment approaches, especially:
- Evaluating and measuring funding ratio risk in institutional (e.g., pension) and goal-based (e.g., individual) portfolios
- Analyzing asset-liability management (ALM) strategies, including surplus volatility and immunization
- Designing and applying funding ratio glidepaths and understanding their impact on risk positioning over time
- Comparing the strengths, weaknesses, and implementation challenges of glidepath and funding ratio-based asset allocation frameworks
- Applying these concepts via quantitative and qualitative exam questions involving surplus tracking and dynamic allocation
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is funding ratio risk, and how does it differ from traditional portfolio volatility?
- Describe how a funding ratio glidepath operates in a liability-driven investment framework.
- How does surplus volatility influence investment policy for a pension fund?
- Briefly explain the purpose of dynamic glidepaths in a goal-based portfolio context.
Introduction
Meeting future commitments—whether pension payments or individual financial goals—often requires more than maximizing returns or minimizing simple portfolio volatility. Modern asset allocation frameworks incorporate the interplay between assets, liabilities, and specific funding objectives. Approaches that account for the risk of failing to meet future obligations include funding ratio management, liability-driven investing, and glidepath design. These methods are central for institutional investors like defined benefit pension plans and increasingly applied in goal-based frameworks for individuals. This article explains funding ratio risk, surplus volatility, and the rationale for risk-adjusted asset allocation over time, equipping you with assessment-ready understanding for the CFA Level 3 exam.
FUNDING RATIO RISK: CONCEPTS AND MEASUREMENT
The funding ratio is a core metric for liability-driven and goal-based investors. It measures the relationship between the current value of assets and the present value of liabilities or future goals.
Key Term: funding ratio
The ratio of the current value of plan assets to the present value of plan liabilities.
Funding ratio risk refers to the uncertainty in this measure over time—how volatile the ratio is due to movements in both asset and liability values. Unlike traditional risk measures, which typically focus on the portfolio's standard deviation, funding ratio risk focuses on the sufficiency of assets relative to future commitments.
Key Term: funding ratio risk
The potential for the funding ratio to move adversely, resulting in an asset shortfall relative to required liabilities or goals.Key Term: surplus volatility
The standard deviation of the difference between asset returns and liability returns, measuring risk in terms of changes to the net funding position.
Increasing funding ratio risk means greater likelihood of a shortfall and higher uncertainty in meeting obligations—central for institutional portfolio design.
LIABILITY-DRIVEN INVESTING AND THE ROLE OF THE GLIDEPATH
The Liability-Driven Mindset
Liability-driven investing (LDI) explicitly accounts for how assets and liabilities interact. Here, risk is defined as the chance that assets will be insufficient at key future dates given liability payments or goal cash flows. ALM strategies use metrics such as surplus volatility and funding status rather than simple asset volatility.
Key Term: glidepath
A predetermined roadmap for reducing (or altering) portfolio risk as funding status or time horizon changes, typically by adjusting the allocation to growth versus defensive assets.
A glidepath may be expressed as a formula (e.g., percent in equities as a function of funding ratio or years to target), a table, or a set of dynamic rules.
Funding Ratio Glidepaths
A funding ratio glidepath provides a disciplined schedule or rule for adjusting portfolio risk exposure based on current funding status. It typically lowers allocation to risky assets as the funding ratio improves and increases risk tolerance if the funding ratio falls to restore target status.
Why Glidepaths?
- When underfunded, accepting more investment risk may help regain target status—provided the sponsor can tolerate the possibility of further deterioration.
- When fully funded (or overfunded), reducing risk helps preserve the cushion and avoid falling below a critical threshold.
- Dynamic glidepaths allow for pre-committed, rules-based risk management rather than ad hoc decision-making.
Worked Example 1.1
A defined benefit pension scheme has an asset value of $1.1 billion and a present value of liabilities of $1 billion. The current funding ratio is thus 1.1. Its investment policy states: "If the funding ratio exceeds 1.1, reduce equity exposure from 60% to 40%. If the funding ratio falls below 1.0, increase equity allocation to 70%." If market distress causes both assets and liabilities to fall by 10%, what action should the fund take?
Answer:
After a 10% asset fall: $1.1bn x 0.9 = $0.99bn. Liabilities fall to $0.9bn. New ratio = $0.99bn/$0.9bn ≈ 1.10. Since the ratio is at the threshold, maintain equity at 40%. If markets fell a bit further and the ratio dipped below 1.1, equity would be increased as per the glidepath.
MEASURING AND MANAGING FUNDING RATIO RISK
Surplus Volatility vs. Portfolio Volatility
Funding status can deteriorate rapidly if asset and liability returns become uncorrelated under stress. Asset-only volatility ignores shifts in liability values.
Surplus volatility captures "true" risk to funding objectives:
- Surplus return = Portfolio return – Liability return
- Surplus volatility = SD(surplus returns), not just portfolio SD
Exam Warning
The CFA exam often tests comprehension of surplus volatility: Many candidates mistakenly focus on portfolio standard deviation alone. Always assess risk in terms of asset-liability interaction.
Sensitivity to Asset and Liability Moves
A key element of funding ratio risk management is to quantify, stress test, and simulate how the funding ratio changes given scenarios for both asset and liability valuations.
Key Term: asset-liability management (ALM)
The coordinated management of assets and liabilities to optimize funding status and meet payment objectives, typically using surplus volatility and funding ratio as core metrics.Key Term: dynamic glidepath
A rule or schedule that adjusts the portfolio (risk or asset mix) over time in response to funding status or time remaining, often used in LDI and goal-based frameworks.
GLIDEPATHS IN GOAL-BASED PORTFOLIOS
Glidepaths are also prominent in goal-based investing for individuals. Here, the target funding level is set for a personal or household objective (e.g., retirement). The allocation to risky assets is systematically reduced as the goal date approaches or as assets accumulate relative to the required future sum.
- "Time-based" glidepaths: Shift from equities to bonds as the goal date draws near (common in target-date funds).
- "Funding status glidepaths": Reduce risk as wealth outpaces required goal funding, increase risk if falling behind.
Worked Example 1.2
Maria aims to fund her child's university tuition in 15 years, estimated at $200,000 in today's terms. She invests in a portfolio with a dynamic glidepath: 90% equity at wealth less than target (below $150,000 present value), cutting to 50% equity once assets reach $180,000 (present value of tuition at current date). How does this approach help?
Answer:
The glidepath increases upside potential when she lags her goal, but preserves capital by reducing equity once sufficiently ahead—minimizing the chance that adverse markets leave her short at the last moment.
RISK BUDGETING AND GLIDEPATH DESIGN
Effective risk management requires explicit risk budgets—rules for how much surplus volatility or funding ratio risk is tolerable at different statuses.
- Step 1: Set a risk budget in terms of surplus volatility or maximum tolerable shortfall probability.
- Step 2: Specify the glidepath/rules for changing allocations as funding status or time changes.
- Step 3: Monitor asset-liability performance and rebalance as needed.
Revision Tip
Dynamic glidepaths are effective only if monitored and regularly enforced. For exam scenarios, always state the importance of ongoing tracking.
LIMITATIONS AND PRACTICAL CHALLENGES
While glidepaths provide rule-based discipline, they are not foolproof:
- Sudden liability shifts (e.g., due to changes in discount rates or mortality assumptions) can trigger unexpected risk budget breaches.
- Overly rigid glidepaths may miss opportunities for opportunistic risk-taking or risk reduction.
- Asset-liability correlations can change unpredictably, affecting surplus risk in ways simple risk models may not forecast.
Summary
Liability-driven and goal-based investing shifts risk measurement from asset volatility to the risk of not meeting future obligations—operationalized via funding ratio risk and surplus volatility. Dynamic glidepaths are practical tools for adjusting portfolio risk over time or as funding status changes, balancing the trade-off between return-seeking and risk-reducing allocations. Effective implementation requires robust risk budgeting, ongoing monitoring, and critical awareness of the assumptions and limitations of glidepath logic.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and explain funding ratio risk and surplus volatility in portfolio management
- Apply asset-liability management concepts to both institutional and goal-based portfolios
- Design and interpret funding ratio and time-based glidepaths
- Manage surplus volatility within risk budgets using dynamic rebalancing rules
- Assess limitations and practical implementation challenges for glidepath frameworks
Key Terms and Concepts
- funding ratio
- funding ratio risk
- surplus volatility
- glidepath
- asset-liability management (ALM)
- dynamic glidepath