Explanation:
Correct answer: A
When interest rates rise, the present value of future liabilities falls because those cash flows are discounted at a higher rate. In a defined benefit pension fund, liabilities are typically longer duration than assets, so they are usually more sensitive to interest-rate increases than the asset portfolio.
In this scenario:
Because the liabilities generally fall more than the assets do, the funded status improves.
So the most likely outcome is an improvement in funded status because present value of liabilities decreases more than assets decrease.
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Q-1.1. A defined benefit pension fund is 50.0% invested in equities and 50.0% invested in bonds. If we assume the simplest possible balance sheet, which is MOST LIKELY to be the net effect of a scenario where equities are approximately flat, but interest increase by 100 basis points? Please note this inspired by Hull’s EOC Question 3.18², so it makes simplifying assumptions such as (i) the rate increase is a parallel shift of both short- and long-term interest rates, (ii) durations are not managed, and (iii) the fund is not hedged.
A
Improvement in funded status because present value of liabilities decreases more than assets decrease
B
Improvement in funded status because present value of assets increases more than liabilities increase
C
Deterioration in funded status because present value of liabilities increases more than assets increase
D
Deterioration in funded status because present value of liabilities decreases more than assets decrease