Evaluating Duration Matching for Pension Liabilities

ABC Corporation is facing a significant pension liability due in 15 years, which amounts to $100 million. The company’s investment committee has decided to implement a liability-driven investment (LDI) strategy that focuses on duration matching to mitigate interest rate risk associated with this liability. Current market conditions indicate that long-term interest rates are at historically low levels, and there is a high degree of uncertainty regarding future interest rate movements.

The investment committee has outlined the following constraints: the investment portfolio must maintain a duration of no more than 10 years, and the allocation can include corporate bonds, government bonds, and derivative instruments to adjust duration. The committee seeks to establish a bond portfolio that mimics the expected cash flows of the pension liability while managing the associated risks.

In your response, analyze the suitability of duration matching as a strategy for ABC Corporation. Discuss the benefits and limitations of this approach in the context of their specific liability, the current interest rate environment, and potential implications of failing to achieve effective duration matching.