An Introduction to Asset-Liability Modeling by gregoria

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									                  Hewitt Investment Group                                                  March 2003
                                                                                          January 2004




An
                  In Brief
                  Synopsis: The recent pension crisis has compelled pension plan sponsors to
                  become more aware of the potential impact that a pension plan may have on the
Introduction to   corporate enterprise. Specifically, plan sponsors have become more concerned with
Asset-Liability   understanding how various pension investment strategies relate to pension
Modeling          liabilities, and what implications these strategies have for the sponsoring company.
                  Asset-Liability Modeling (ALM) provides a tool for plan sponsors to address these
                  issues. This paper gives an introduction to ALM, differentiating ALM from the more
                  traditional, asset-only based approach to the asset allocation decision.


                                    Traditional Efficient Frontier Analysis
                  EXPECTED RETURN




                                                                              RISK



                  Shortcoming of Traditional
                  Asset Only Portfolio Modeling
                  Modern Portfolio Theory (MPT), originally pioneered by Nobel Laureate Harry Markowitz
                  and later augmented by Nobel Laureates Merton Miller and William Sharpe, provides a
                  framework for constructing efficient investment portfolios. MPT mathematically quantifies
                  the intuitive concept of diversification by demonstrating that an “efficient frontier” of
                  optimal portfolios can be created by combining various risky asset classes, whereby each
                  portfolio offers the highest expected return for a given level of risk.




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MPT holds that the proper way to construct a prudent investment portfolio is for the
investor to: 1) decide on the level of risk he/she is able/willing to tolerate, and
2) Identify—through efficient frontier analysis—the optimal portfolio, offering the highest
expected return for the specified level of risk. The shortcoming of efficient frontier
analysis—as it relates to investing pension assets—lies in the fact that identifying the
expected return and risk of a certain asset mix only captures half of the picture. Efficient
frontier analysis defines risk simply as the variance in the range of possible investment
returns for a given portfolio. Efficient frontier analysis does not address the risk of an asset
mix as it relates to pension liabilities—which pension assets must ultimately fund.

A very interesting two-year period from 1994 to 1995 crystallizes this important point.
According to data compiled by Ryan Labs, the typical pension fund returned –0.02% in
1994. In the more traditional, asset-only construct of efficient frontier analysis, 1994
would seem to have been a very bad year for pension plan sponsors, as most plan sponsors
assume their pension funds will return around 8% per year. What we don’t see, however,
in efficient frontier space is the other half of the equation. In 1994, interest rates rose
substantially resulting in increased actuarial discount rates, thus lowering the present value
of pension liabilities. According to Ryan Labs, the value of liabilities for a typical pension
plan fell by 12.60% in 1994. Therefore, 1994 was actually a very good year for pension
plan sponsors, as the funded status of the typical pension plan improved by 12.58%
(barring contributions and benefit payments).

1995 was a direct reversal of 1994. In 1995, the average pension fund returned 28.70%.
Again, from an asset-only perspective, this would seem to have been a terrific year.
However, interest rates fell precipitously in 1995, leading to lower actuarial discount rates
and greater present values of pension liabilities. In fact, the value of liabilities for the
average pension plan grew by 41.16%, resulting in a net change to the funded status of the
average plan of -12.46%. Thus, despite the year’s tremendous investment returns, 1995
proved to be a terrible year for pension plan sponsors.


                     Pension Fund          Change in Value of             Net Change in
                        Return             Pension Liabilities        Pension Funded Status

1994                    –0.02%                  –12.60%                       12.58%

1995                    28.70%                    41.16%                     –12.46%




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Why Asset-Liability Modeling (ALM) Is Superior
to Asset Only Portfolio Modeling
In conducting ALM, we endeavor to evaluate the risk/reward profiles of various asset
mixes. With ALM, however, we define risk and reward not in terms of the performance of
an investment portfolio, but rather we define risk and reward in terms of the overall health
of the pension plan and the impact the pension plan has on the sponsoring corporation and
the plan participants.


                                    Simulate Thousands
                                   of Economic Scenarios
                                     Capturing Varying
                                    Inflation and Interest
                                     Rate Environments



                                                                      Relate Economic
      Relate Economic                                                   Scenarios to
     Scenarios to Value                                            Performance of Various
    of Pension Liabilities                                          Investment portfolios


                                 Capture Relevant Measures
                                  of Risk and Reward for
                                 Pension Plan Sponsors and
                                      Plan Participants

                                    •Pension Expense
                                    •Cash Contributions
                                    •Funded Ratios




To do this, we stress test the performance of various asset mixes in thousands of different
economic scenarios—representing varying inflation and interest rate environments.
Simultaneously, we evaluate the influence that each of the economic scenarios will have
on a pension plan’s liabilities. With a thorough understanding of how a pension plan’s
assets and liabilities will jointly behave, with varying asset mixes, under thousands of
different economic scenarios, we are then able to produce statistical projections of various
measures such as accounting expense, cash contributions, and funded ratios. These results,
which integrate the experience of both the pension assets and liabilities, provide a pension
plan sponsor with a complete picture of how the pension plan will likely impact both the
sponsoring company and the plan participants.




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Hewitt Investment Group                                       4                             March 2004




Defining the Ends of the Spectrum
Changes in the value of pension liabilities are most strongly influenced by fluctuations in
long-term interest rates. Therefore, pension liabilities generally behave like long-term
bonds. Accordingly, the obvious approach for a pension plan sponsor to maintain a stable
funded level and create a predictable pattern of future costs is to invest 100% of the
pension assets in a portfolio of long-term bonds, having the same sensitivity to fluctuations
in interest rates as the liabilities.


    Benefits Paid
  + Administrative Costs
  – Investment Returns
  = Ultimate Pension Cost



The drawback to this volatility-minimizing approach can be easily crystallized with the
basic equation for pension cost. As we can see (above), the long-term cost to a pension
plan sponsor consists of the benefits paid, combined with various administrative costs,
and offset by investment returns. It is not difficult to discern that higher investment returns
ultimately lower the long-term cost of a pension plan. Investment in an all bond
portfolio—having very limited upside return potential—inherently locks the plan sponsor
into an unavoidable stream of future pension costs that may or may not be tolerable to the
ongoing corporate enterprise. Let’s take a quick look at an example to highlight this point.


Projected Benefit Obligation (PBO)   $1 Billion                            Pension Assets    $1 Billion

            Interest Expense (6%)    ($60 Million)          Return on Bond Portfolio (6%)    ($60 Million)

      Annual Benefit Accrual (5%)    ($50 Million)                  Cost to Plan Sponsor     ($50 Million)

          Total Annual Cost (11%)    ($110 Million)   Amount Needed to Match PBO (11%)       ($110 Million)


As the example demonstrates, the investment return of a duration-matched bond portfolio
should cover the interest expense on the liability and should also match any changes in the
liability value related to fluctuations to the liability discount rate. However, the annual
accrual of newly earned pension benefits (around 5% for a typical pension plan with a
majority of active participants) would not be covered by investment returns. This annual
benefit accrual would, therefore, result in an annual cost to the plan sponsor ($50 Million
in our example).

The primary argument for including stocks in a pension fund is that stocks, given a
sufficiently long investment horizon, should ultimately reduce the long-term cost of
maintaining a pension plan, as stocks, on average, are expected to outperform bonds. In
our example, if we assume that a portfolio composed of 65% stocks and 35% bonds would
return around 8% per year, the annual expected cost savings to the plan sponsor would be
about 2% (or $20 Million and growing).




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Hewitt Investment Group                                5                      March 2004




The drawback, of course, is that stocks do not always outperform bonds. Investing in
equities creates a behavioral mismatch between pension assets and liabilities. This
mismatch arises because liability values are primarily influenced by changes in long-term
interest rates, while equity values are driven by a multitude of factors other than interest
rates. The behavioral mismatch between assets and liabilities, over a short-term period, can
lead to increased cash contributions and accounting expense, as well as a reduced funded
ratio. It is worth noting, though, that smoothing mechanisms currently present in both
pension accounting and funding rules provide a cushion, which lessons the impact of
unfavorable scenarios.

Who Bears the Risk?
In the U.S., governance over pension assets is typically carried out by a committee,
composed of members of the sponsoring company’s senior management. Committee
members face a difficult task in making investment decisions for pension assets due to an
inherent conflict of interest. Committee members, themselves being company employees,
clearly have a vested interest in the ongoing success of the company. They also have an
obligation, as company employees, to promote policies that lead to the creation of value
for company shareholders. Committee members, however, aside from their obligations as
company employees, wear a second hat—that of named fiduciaries to the pension plan
assets. In this regard, as prescribed by ERISA law, pension fund fiduciaries are required to
make investment decisions pertaining to pension assets based on a consideration of what
will best serve the interests of the pension plan participants.

Although the overarching objective of successfully paying out all pension benefits without
significantly harming the financial health of the company would seem to be shared by all,
there may be a subtle difference related to the focus of the interested parties.




As we’ve shown, higher returns lead to lower costs. In theory, the sponsoring company
should be able to translate any cost savings into increased value for shareholders. Given
the potential benefit to shareholders, a plan sponsor may be willing to accept the short-
term risk presented by equity exposure, particularly if the plan sponsor considers the
pension plan to have a very long-term investment horizon (as defined by the demographic
characteristics of the plan participants). Thus, from the company’s perspective, the goal of
the pension investment program should simply be to minimize the long-term cost of the
pension plan, while maintaining a tolerable level of annual volatility.




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                                        Hewitt Investment Group                                6                       March 2004




                                        Conversely, pension plan participants ultimately receive benefits that are defined by the
                                        plan provisions, and which are not directly impacted by investment returns. The potential
                                        cost savings derived from investing in equities are not necessarily passed on to plan
                                        participants (although cost savings could, theoretically, translate into a richer benefit
                                        formula for employees). Thus, from the perspective of the plan participants, the primary
                                        focus of the pension investment program should be to ensure that the plan remains fully
                                        funded at all times. The most undesirable situation for a participant is a confluence of
                                        events whereby the pension plan becomes underfunded and the plan sponsor is rendered
ATLANTA                                 unable to make contributions necessary to recoup the funded deficit.
3350 Riverwood Parkway
Suite 80                                The importance to participants of a stable funded status does not imply that participants
Atlanta, GA 30339                       have no vested interest in controlling the long-term cost of a pension plan. If the cost of a
770-956-7777                            pension plan becomes overly burdensome, the plan sponsor may choose to freeze or
                                        terminate the plan. Moreover, a plan sponsor may be forced to eliminate employees,
                                        should circumstances become dire enough. None of these actions can be deemed to be
LINCOLNSHIRE                            beneficial to plan participants.
100 Half Day Road
Lincolnshire, IL 60069                  Summary
847-295-5000
                                        By properly defining risk and reward in terms of both assets and liabilities and by
                                        quantifying the risk-reward trade-off of various investment approaches, ALM enables a
NORWALK                                 pension plan sponsor to identify the approach that fits best within the overall corporate
45 Glover Avenue                        finance strategy. This chosen investment approach should allow the plan sponsor to
Norwalk, CT 06850                       maintain the pension plan for an affordable cost, while offering participants a high level
203-852-1100                            of assuredness that their future benefit payments will be made.




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