Turbulent times and strict funding regulations have brought ALM to the fore again, reports Elizabeth Pfeuti
This stress, coupled with increased regulation and pressure on corporate sponsors to fill any gaps in scheme funding, has once more made asset liability modelling (ALM) an important consideration for pension funds.
Joe Moody, head of liability driven investing, State Street Global Advisors (SSgA), said: "Market turmoil has brought these issues to a head as it has become difficult for managers to outperform in such difficult markets."
The first investment decision trustees must tackle is acknowledging what the fund needs before going looking for it. In this way, ALM is a type of risk management shopping list.
For some pension funds, ALM has long been the strictly adhered to route map for any investment decision. Others have been more reticent, believing there to be safety in numbers and opting instead to follow the institutional herd when allocating their assets.
John Gillies, a director in Russell's investment strategy and advice team, said the industry had made great strides since the 1970s and 80s when pension fund investment was often based on keeping tabs on other company schemes' investment tactics.
Gillies explained: "Recognition of liabilities was pretty crude, it was technically an asset allocation model which would typically be a mean variance optimiser a la Markowitz' with some kind of penalty for the liability growth rate."
In other words, focus your attention on the asset characteristics but make allowances by deducting the liability growth rate to produce something like a real rate of return which would be specific to that particular fund.
Happily, things have moved on. Marcus Hurd, senior actuary, Aon Consulting, explained the root of today's modern process: "We take the calculations of what assets and liabilities look like separately then work on how to get the two working together more effectively."
Kevin Carter, head of JPMorgan's Pension Advisory Group, expanded: "ALM is a phrase which incorporates a range of tools. It's the starting point for every pension scheme, as without it there is no framework to organise assets to meet the liabilities they are obliged to meet."
It would seem common sense to most to have some idea of what a pension fund has to achieve before trying to find a route to attain it and ALM can help, but it can only help.
Bob Burke, investment director, Financial Strategies Group, Mercer, clarified: "Modelling is a tool, like an x-ray. It does not tell you what to do or how to do it. It shows a 3-D view of the risks a pension fund must tackle."
Burke added: "ALM will not give standard prescriptions and only provides one piece of the picture."
Phil Garcia, director, client service EMEA, T. Rowe Price, continued: "Trustees look to add value with each solution. ALM is not a solution in itself, however, it is something to help you understand the dynamics of what's going on."
Portfolio diversification along with other analysis modelling techniques would help equip a pension fund to manage its risk profile to withstand times of high volatility and look to the long term.
Carter added good ALM should incorporate some sort of longevity risk along with liability and asset risk. He said trustees should be aware this was an important factor when considering any shortfall a sponsor's covenant would have to bridge.
Like other consultants, Mercer carries out additional exercises to produce a more detailed view of a pension fund's investment and risk management needs, such as the maturity of a scheme, a company's financial position and risk appetite.
Clearly ALM is not a simple calculation. When dealing with the sheer size and membership of pension schemes, trustees have to bring in the professionals.
Assets have to be examined in terms of return rate, correlation and volatility. Interest rates and inflation, not forgetting accounting standards and regulation, also impact on assets and liabilities.
Once that has been established, a consultant or fiduciary has to come up with an investment strategy reflecting the amount of risk the ALM has highlighted could or should be taken.
Impact of diversification
The increased diversification in available asset classes over the last ten years has created another facet to ALM.
Garcia at T. Rowe Price commented: "More moving parts makes things more complicated."
He added: "Traditional asset liability models may not have the data required to make a suitable process for this wider range of investment opportunities. The historical data just doesn't exist for newer, alternative investments."
Hurd at Aon said from an actuary's point of view, adding non-mainstream asset classes into the mix made the process more interesting.
It has been well documented that a portfolio with exposure to a larger universe of investment options would also show the pension fund to have lower volatility and correlation between assets. This would help manage risk profiles in the medium to long term.
Robert Hayes, head of strategic advice services at BlackRock, said pension funds had begun seeking more diversified portfolios, but still wanted them to fit with the risk profile and diagnosis produced by ALM.
However, Hayes confirmed the thoughts of many actuaries, consultants and asset managers: "ALM suffers from a Ôgarbage in, garbage out' syndrome. It's often not that we need more sophisticated models, just more common sense."
Hayes expanded on this with the example of a fund doing ALM every three years starting from 1996. The assumptions of equity returns remained the same during the next two cycles in 1999 and 2002, during which time the FTSE rose from 3,000 to 7,000 and came back down again.
He commented: "Quite rightly, a lot of funds found their first ALM was scientific and confusing, the second time thought they understood it so were reassured, [but] the third time realised it hadn't helped at all."
Hayes added some asset classes such as hedge funds, infrastructure and commodities were immensely sensitive to inaccurate assumptions.
Carter agreed trustees should allocate more time to reviewing the information put into models, as currently the system was not working to its full potential.
"Trustees have to have confidence the models actuaries use work, but they cannot afford to be blinded by the science."
Carter said more time should be spent ensuring the correct information was being used to produce accurate diagnoses, or the process was worthless.
To an outsider, ALM would seem imperative to any pension fund at any stage of its cycle or funding level.
However, the reality is more complex.
Antigone Theodorou, director of investment solutions, AXA IM, said around 10% of UK pension funds had implemented liability driven investments.
Theodorou continued: "More pension funds than we predicted have opted for this type of solution to cover their risk exposure."
She explained pension funds had always carried out ALM in some form, but liabilities had not been so large a part of the picture until recently due to the financial climate. Regulation, accounting and a change in market conditions in 2000-01 coincided to bring ALM to the fore.
Hurd at Aon said there had been a lot of development in the LDI space in recent years.
He continued: "Until recently, LDI solutions were the reserve of larger funds, but these institutions were often too large to go in as they would distort the market."
Garcia said large pension funds were using straightforward investment tools for the bulk of their portfolios, with specific overlay structures to target liabilities. Smaller schemes, however, were looking to simpler, more cost effective options.
Theodorou said most of AXA IM's LDI clients had taken a step-by-step approach. They initially bought into the idea of interest rate and inflation hedging, mostly through existing fixed income holdings.
She said as trustees became more comfortable with innovative, more complicated structures, they were entering further into the space.
Hurd added there were a few reluctant trustee boards who were convinced of their need to be in a certain asset class and would not be swayed by ALM results, but on the whole, pension schemes realised their value.
Essentially, ALM in any form is a mainstay for any pension fund investment, more so today due to volatile markets, but also increased regulatory and accounting standards pressure.
Burke at Mercer predicted ten years from now, investors would be better at putting pieces together using new effective risk management tools and techniques. He concluded: "ALM hasn't gone away. It's a way to focus on both sides of the problem and use tools you can get comfortable with to develop a longer term strategy."
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