Ch 5 Lifecycle Investing

Question 1

Investment objectives often framed from Risk & Return perspective;
Sometimes need to cater for specific liabilities the investment is designed to fund
Examples

Answer 1

1. Insurance:
   a) Life/TPD – low probability of event, but with a high claim amount
   b) Salary Continuance – higher probability of an event, with an uncertain claim amount
   c) Motor – predictable probabilities of events, with low claim amount
   d) Home – mixture of predictable probabilities of events with low claim amount (burglary), and low probability with high claim amount (natural event)
2. Retirement savings
   a) Defined benefit pension/Annuity – known outgoings over an uncertain but effectively capped timeframe
   b) Defined contribution – known but capped outgoings over an uncertain timeframe

Question 2

Asset-Liability modelling solutions

How to introduce liability asset to standard MV problem, single period solution (2)

Answer 2

1. Liabilities have means, variance & correlations just like other assets
2. Force liability to have -100% exposure, and solve for asset exposures to offset

Question 3

Asset-Liability modelling solutions

How to introduce liability asset to standard MV problem, multi period solution (3)

Answer 3

1. Liability Replicating Portfolios – ensuring the assets (often fixed income) have as similar characteristics to the liabilities. E.g. duration, coupon payments, etc.
2. Cashflow Matching – a less constrained version of liability matching – ensures that asset cashflow match expected liabilities. This is useful when liabilities are predictable.
3. Simulation – multi-period simulations of both the liabilities and assets of insurance P&L - reinvesting surpluses, creating actuarial reserves.

Question 4

Life Cycle Investing

A Key qn by superannuates
B What analysis is generally used because of longer time frames and impact of small changes to parameters

Answer 4

The key questions asked by superannuates are:
1. How long will my money last?
2. How much income can I draw?
3. What impact will the investment strategy have upon my balance?
The long time frames involved and the potential impact of small changes to parameter (e.g. savings rate & taxation), makes this an problem suitable for Monte-Carlo simulation

Question 5

Strenths and difficulties of projection method vs MV optimisation

Answer 5

Strengths of simulation (Projection) method vs MV optimisation
● Projections of net income and profit, both before and after tax, are available
● Path of future statutory and accounting ratios can be estimated
● Evolution of surplus can be followed over time
Difficulties of Projection Method
● Changes in AA need to be specified or need to be an objective of optimisation
● Projection of CFs needs more complicated specification (increase estimation & model error)
● Original AA may be overly dependent on shape of liability CFs even if imprecise
● # calculations is large, could be many local optimums