By Jan Willem Stuijvenberg
and Arun Muralidhar
There has been a growing emphasis on pension fund liability management and creating a portfolio of assets to match these obligations.
One strategy seeks to protect pension fund solvency through the immunization of liabilities. Variations have ranged from the approach of the pension fund of Boots Co. PLC, Nottingham, England, which converted its entire portfolio into fixed-income assets (since revised to include a small allocation to other asset classes) to a complete abandoning of the strategic asset allocation policy in favor of a totally tactical policy or to duration extension combined with portable alpha.
However, the principal challenge to developing an optimal policy for managing the assets-to-liabilities ratio (also called the funded ratio) has probably more to do with better understanding of the liabilities than in developing innovative investment policies.
This renewed interest in asset-liability matching is mainly caused by the rapid decline in interest rates, which led to an increase in most pension plan liabilities on a mark-to-market basis. Unfortunately for most pension funds, this decline in rates coincided with a decline in many stock markets. The fall in the value of assets at a time when the value of liabilities was increasing led to a dramatic decline in the ratio of assets to liabilities. This ratio is often what regulators, chief financial officers and others look at to judge whether a plan is solvent and healthy. Further, accounting standards imply that pension fund losses can affect the corporate pension fund sponsor because unfunded liabilities have to be disclosed in the financial statements and shortfalls have to be made whole through corporate contributions. For these reasons, many pension plans worldwide are adjusting their investment and hedging strategies to reduce the impact of a declining (and volatile) funded ratio.
Pension funds often find it difficult to express the desired approach and implementation of "liability-driven" investments to their asset managers. The main problem pension executives encounter is in setting an appropriate investible benchmark that reflects the liabilities.
In this short article we describe a simple, stable and accurate benchmark to mimic liabilities based on daily available swap indexes. The only input needed is the projected annual liability cash flows. We'll use the work done at the €17 billion ($20 billion) Bedrijfstakpensioenfonds Metalektro in Schiphol, Netherlands, also known as PME, to illustrate our views.