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Balance Sheets Best Practice

Asset Liability Management for Pension Funds

by Ruud Kleynen

Table of contents

Executive Summary

  • Asset liability management (ALM) is an overall risk management technique for pension funds.

  • ALM requires the board to formulate guidelines for its strategy on contribution and indexing levels, and its attitude to risk.

  • ALM is based on stochastic simulation and is used as a basis for decisions on the distribution of future contributions, funding, and indexing levels.

  • Practicing ALM requires an assets and liabilities committee (ALCO). An ALCO consists of senior pension fund management, with the chief risk officer as chairman. The committee converts the guidelines into formal proposals on the investment strategy and the contributions and indexing policies.

  • ALM does not predict the future, but it gives insight into the possible risks a pension fund is exposed to and how to handle them.

  • An ALM model should be as parsimonious and uncomplicated as possible. The purpose of such models is to act as a tool to help management understand what is really going on, and how to reach responsible and internally consistent decisions.

 

Introduction

The management of a pension fund has to make decisions about its strategic asset allocation, its contributions policy, and its indexing policy in a context of acceptable financial risk. It has to meet the return requirements necessary to improve benefit payments on the one hand, and to stay in line with the solvency requirements of the regulator on the other. But what is an acceptable contributions and indexing policy, and how is an acceptable risk attitude defined? ALM forces the board to think about these aspects, and to quantify them. That is not an easy job. But only by giving clear guidelines does risk management have practical and measurable value. Putting ALM into practice is not a solo achievement but requires a multidisciplinary team of specialists who are willing to work together. Formalization normally results in the so-called assets and liabilities committee, or ALCO, with the chief risk officer as chairman.

The Aim of ALM

A crucial stage in the exploration of an ALM strategy is the development of the funding level. The funding level is the ratio of the market value of the assets and the market value of the liabilities. Funding levels below 100% are disliked because the assets do not cover the total value of the liabilities. So management of the funding level in general, and the possibility of underfunding in particular, is of primary importance. Generating high funding levels is easy to accomplish. Just increasing the contributions and investing them in low-risk assets will generate attractive funding levels. However, neither employers nor employees will be too enthusiastic about this solution because they are faced with high pension contributions.

Another important concern is the indexing policy. Pension funds aim to index their benefit payments based on the price inflation of the previous year to protect pensioners from loss of purchasing power. Such indexing clauses are conditional, as full indexing can only be implemented if the funding level is high enough. The closer the funding level falls to the 100% mark, the less the benefits will be increased. If benefit payments are to be made inflation-resistant, adequate indexing levels are very important.

ALM, therefore, is the search for a balanced perspective. By practicing ALM we want to find a balance between future contributions on the one hand and future funding and indexing levels on the other. To accomplish this, the choice of strategic asset allocation plays an important role, as Figure 1 shows.

Why Is ALM Important?

Within a pension fund, investment managers, risk managers, accountants, actuaries, CEOs, and CFOs have to communicate, and communication is not that easy. How nice it would be if we all spoke the same language. ALM helps us. ALM is a technique that pension funds employ in coordinating the management of assets and liabilities. An ALM approach forces all parties to quantify the relevant factors and bundles them into an overall framework. The effects of separate decisions are analyzed in an overall context. Isolated decision-making is no longer possible. ALM is therefore a financial risk assessment and asset planning tool used by pension funds to help them choose the strategic policy under uncertainty, and in a coherent and consistent balance sheet approach.

ALM Modeling

In the complex environment in which pension funds have to operate, ALM requires an instrument to identify and manage risks. Such an instrument is a stochastic simulation model, which mimics the behavior of a pension fund by incorporating randomness to obtain a statistical sample of possible outcomes. ALM modeling is thus a key method in strategic risk management. It involves developing mathematical scenarios of the future evolution of assets and liabilities, given certain assumptions about the statistical properties of the variables that affect the evolution of assets and liabilities. Though dynamic models have proven a better fit for real world scenarios, they do have their drawbacks, as due to their complexity they may be harder to understand and interpret.

There are many ways to generate these scenarios. The traditional method was to create a central scenario, and to carry out some stress testing around it. With time the models have become more sophisticated, involving stochastic simulation of assets and liabilities. Modern ALM studies rely on stochastic models that generate thousands of scenarios, with different probabilities attached to each. While the traditional ALM studies focused on asset optimization with a deterministic view of liabilities, today ALM is increasingly used to simulate the consequences of policies for different stakeholders while complying with the requirements of the regulatory authorities. In this sense, ALM systems are used as integrated planning systems to simultaneously determine investment, funding, and—if applicable—indexation policies, thereby balancing the goals of the different stakeholders. Each ALM system has its own unique characteristics, principally governed by the underlying stochastic processes and distribution functions.1 The main financial uncertainty comes from changing asset prices and interest rates, and from transition probabilities. But how do they behave? Questions such as “Are there differences between short-term and long-term behavior?”2 have to be asked, and if the answer is yes, they should be modeled. Furthermore, modeling normally concentrates only on stocks and bonds, so the question arises whether investment products should also be included.3

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Further reading

Articles:

  • Campbell, J. Y., and L. M. Viceira. “The term structure of the risk–return trade-off.” Financial Analysts Journal 61:1 (2005): 34–44.
  • Gerstner, T., et al. “A general asset-liability management model for the efficient simulation of portfolios of life insurance policies.” Insurance: Mathematics and Economics 42 (2008): 704–716.
  • Gibbs, S., and E. McNamara. “Practical issues in ALM and stochastic modelling for actuaries.” Paper presented to the Institute of Actuaries of Australia Biennial Convention, September 23–26, 2007.

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