C15 - Asset Liability Modelling

Question 1

Why should we review the continued appropriateness of an investment policy regularly?

Answer 1

• Liability structure may have changed significantly
• Funding position may have changed significantly
• Investment manager/vehicle performance may be significantly out of line with other funds

Question 2

Issues to consider when setting the investment policy

Answer 2

• Liability profile
• Funding position
• Size of fund, and whether increasing, decreasing or static
• Expected cashflow and liquidity requirements
• Risk attitude, in particular to accept downside risk

Question 3

Describe how the fund develops for a new scheme with no past service and how this impacts investment strategy?

Answer 3

• Scheme initially has little assets
• Little benefits will be paid out, so assets grow rapidly from incoming contributions
• Terms of liabilities will be longer when Scheme begins and so term of appropriate assets will reduce with time
• Likely consequences of poor investment performance are less for a new scheme and so a high risk/return strategy may be acceptable

Question 4

Reasons why an apparently safe matching investment policy to be unacceptable to the trustees

Answer 4

• Contributions required to finance the scheme may be too high due to the lower expected returns of such a policy
• Reduced uncertainty may also mean surplus and possible benefit improvements are unlikely

Question 5

Conflicting factors when setting a long term investment strategy

Answer 5

• Exposure to return seeking assets to increase surplus but running the risk of a deficit of things turn out worse than expected
• Exposure to stable assets to reduce risk of deficits but leading to smaller or no surpluses, hence higher contributions

Question 6

Describe the ALM process

Answer 6

• Specify objective
• Decide time horizon
• Test strategy by performing a number of simulations
• Measure achievement of objectives
• Vary item being optimised (repeating simulation and measurement process each time)
• Decide which strategies are suitable
• Explain/discuss results with clients
• Test particular strategies more thoroughly
• Give final advice

Question 7

Data and information needed for an ALM exercise

Answer 7

• Clear objectives
• Time horizon
• Stochastic investment model
• Detailed demographic assumptions
• Data required for normal funding valuation
• Details of benefits, options and guarantees
• Funding method and assumptions used to determine funding target
• Number of simulations

Question 8

Describe the two most commonly used economic models in ALM exercises

Answer 8

Random walk - assumes asset values move up and down without changes depending on past asset values, usually from log distributions. fits in well with market efficient theories

Autoregressive models eg Wilkie model - assumes returns gravitates towards a long term mean. Has a built in cascade approach based on inflation, which drives bond yields which turn drive equity yields

Question 9

Why might demographic assumptions used in the ALM exercise differ to those adopted for a regular funding valuation?

Answer 9

• No allowance for margins
• May be supplemented by explicit assumptions about the factors affecting the timing of cashflow that are often ignored in a traditional actuarial valuation eg new entrants, commutation, TV and early retirement take up

Question 10

Define an efficient frontier

Answer 10

A range of sensible investment policies for a particular set of investment return and risk assumptions that minimise variance for a given funding level or contribution rate

Question 11

Why is it important not to overestimate the power of ALM exercises?

Answer 11

Misleading to regard the results as optimal other than in the context of the model, as true underlying distributions of asset classes can only be estimated and there exists sensitivity of the results to assumptions used