Asset liability modelling (Asset liability modelling (ALM to determine an…
Asset liability modelling
Choosing an investment strategy
the nature of the benefit scheme
the liability profile (nature and term)
the financial position (surplus and deficit)
the size of the fund (and whether increasing, decreasing or static)
the cashflow position (and consequent liquidity requirements)
the attitude of the parties involved in the scheme to risk , in particular, their ability to accept downside risk
Investment performance should be monitored regularly and, once set, investment strategy should be reviewed regularly
Liability structure may have changed significantly (e.g. following takeover, benefit improvements, closure to new entrants or to future accrual or legislative changes)
the funding position may have changed significantly (e.g. surplus may have disappeared following a contribution holiday or a refund to the sponsor
the investment manager/ vehicle performance may be significantly out of line with that of other funds
Risk and reward
Increasing exposure to return-seeking investments such as equities to increase expected returns
increasing exposure to investments that more closely match the liabilities, such as government bonds or LDI strategies
Expected returns will be lower, hence contribution will be higher (if events turn our as expected).
Asset liability modelling
For some purposes, cashflow models incorporating stochastic elements are useful.
ALM to determine an investment strategy involves the following steps:
Decide on the time horizon of the simulation
Build a cashflow model of assets and liabilities
Perform a number of simulations
Measure the achievement of the objectives
Vary the items being investigated
Repeat the simulations and measurement and identify a shortlist of potential strategies
Explain and discuss the results to allow the trustees and employer to make a decision.
Objectives must be detailed and measurable
Number of simulations necessary for a reliable estimate depends on what is being investigated.
In general, the more extreme the situation under investigation, the more simulations that are required to analyse it.
The cashflow model of assets will usually employ a stochastic model
The appropriate strategic investment allocation is selected by varying one item (e.g. asset allocation) and selecting the strategy which optimises another (e.g. level of contributions for a given risk appetite)
Further judgement is required before deciding on a strategy.
ALM is a tool to help to illustrate the risks associated with particular investment strategies
It will not state the most appropriate strategy to adopt- misleading to regard the results of an ALM exercise as optimal other than in the context of the model.
Assumes asset values move up and down without changes depending on past asset values. Typically the moves may be taken to be taken from a log-normal distribution. The random walk approach fits well with "market-efficient" theories.
Autoregressive models (e.g Wilkie model)
Assumes returns gravitate towards a long term mean. Has a built in cascade approach based on inflation, which drives bond yields which in turn drive equity yields
No allowance for margins
Additional assumptions surrounding timing of cashflows that are often ignored in a traditional valuation i.e.
% of pensioners taking commutation
% of deferred members taking transfer values
the % of active/ deferred members taking early retirement