Asset & Liability Modelling for Pension Funds

1. Asset & Liability Modelling for Pension Funds Jon Exley & Shyam Mehta June 2000

2. Asset & Liability Modelling for Pension Funds • Observations on current practice • ALM in other financial applications • Objectives • Implications of Value Maximisation • New ALM applications • Conclusions

3. Observations • Different asset models, same conclusions • Different jurisdictions, different conclusions • Different liabilities, same output • Minor assumption changes, different output • Seeks high risk/return, not matching assets • Accuracy is +/- 100%, not +/- 10% without implicit or explicit calibration

4. ALM in Other Financial Applications • Lack of resemblance is striking • Elsewhere focus is on matching • well defined output • very sensitive to liabilities • worthwhile to develop good model/techniques • results tested in real time • Asset model essential for options, in other applications may work direct with data.

5. Objectives • Clear objectives lead to clear conclusions ? • In practice, most objectives “maximise return subject to acceptable risk” • Arbitrary nature of “acceptable” allows results simply to follow convention • Value maximisation gives true clarity • Natural objective, contrast to “risk of ruin”

6. Implications of Value Maximisation • Advise parties separately • But, gain from equity investment for one party is loss to other • If both sides well informed/well served better to maximise aggregate and share

7. Implications of Value Maximisation: Members • Loss of value on default, gain on upside call • Prefer non systematic risk, efficiency useless • Optimal to match, use equity linked funding • Where does traditional ALM fail? • Inadequate focus on solvency events • Discretionary practices not modelled • Focus is not on value

8. Implications of Value Maximisation: Managers • Ideally serve interests of shareholders • In practice may support any ALM which serves own interests • Equity management more fun than admin • Do not bear downside risks personally, enjoy safety in numbers & like systematic risk • Substantial personal interest in pension benefits • Fee income is not proof of correctness

9. Implications of Value Maximisation: Owners • Opposite benefits to members from equities

10. Implications of Value Maximisation: Aggregate • Suppose focus on aggregate, then matching: • focuses management on value building • reduces agency costs • controls cash in business • improves transparency to members • reduced external costs • taxation gains, etc.

11. New ALM Applications • Identifying best match is valuable and challenging • There are risk/return trade offs but different magnitudes (cf realistic equity premium) • illiquidity premiums • disintermediation gains • tax • Direct placings need to be priced/evaluated

12. Conclusions • Existing ALM of questionable value • New ALM applications are possible in value-added framework • Advantages: • accurate liability modelling is valuable • good models/statistical methods worthwhile • judgement still important • coherent theoretical framework