Pension Risk and Asset Liability Modeling for Defined Benefit Plans

1. Actuarial Summit 2014 Pension Risk and Asset Liability Modeling for Defined Benefit Plans México Author: Vineet Hans Date: 13th August 2014 AVISO LEGAL Este material ha sido elaborado y presentado bajo la responsabilidad exclusiva del autor. Los puntos de vista, opiniones y contenido de este material así como los derechos intelectuales son responsabilidad exclusiva del autor a título individual y no representan ninguna de las posturas oficiales de la Agrupación Actuarial CAM, A.C. quienes a través de su marca Colegio Actuarial Mexicano (CAM) y sus miembros no aceptan responsabilidad o pérdida causada por personas o entidades por el uso, actuación o enfoque derivados de la información de sus contenidos, comunicados, seminarios, programas publicaciones o actividades de carácter general, ya sea que dicha responsabilidad o pérdida haya sido causada por negligencia, omisión o alguna otra índole.

2. Pension Risk and Asset Liability Modeling for Defined Benefit Plans • Pension Risk in defined benefit (DB) pension plans • Type of risks in a DB pension plan • Liability Driven Investing (LDI) • LDI Strategies • Typical U.S. Defined Benefit Pension portfolio • ALM process • Generating scenarios – an overview • Generating scenarios – examples • Projected Assets and Liabilities – a snapshot • Determining the best LDI Strategy • Question? • About the Author

3. Pension Risk in defined benefit (DB) pension plans • Over the last 10 years, the defined benefit (DB) pension plans are under tremendous financial pressure to be able to keep solvent. • Most of the organizations still holding huge amount of risk in the portfolio are considering possibilities to manage their risk more effectively i.e. de-risking.

4. Pension Risk in defined benefit (DB) pension plans (cont.) • 2013 saw a sharp level of increase in funding status of many U.S. based DB pension plans but the trend might not continue. • There is a need to reconsider pension de-risking strategies. • Some of the largest U.S. corporate pension plans are already on their way to mitigate pension risk by modifying their asset allocation strategies with others likely to follow suit. GM and Ford

5. Type of risks in a DB pension plan Two major risks: • Interest rate risk – Risk arising out of change in interest rates used to discount liability cash-flows. Easy to quantify. • Longevity risk – Risk the pensioners will outlive the actuarial assumptions. Not so easy to quantify and manage Other Risks: • Credit Risk • Duration mismatch • Inflation Risk • Equity Risk • FX Risk

6. Liability Driven Investing (LDI) • Till recently the pension funds were just managed from the “asset-only” perspective. • Only risk considered was investment risk • LDI strategies seek to align the value of a plan’s assets with itsliabilities as both are affected by market performance and other factors. • The goal is more stability in funded status, required contributions, and balance sheet impact. • LDI recognizes that making a pension plan’s investment decisions based only on maximizing return for a given level of return volatility does not incorporate the plan’s liabilities into the investment decision process.1 1.Source http://www.bondedge.com/us/fi_articles/fi_ldi.html

7. LDI Strategies Basic purpose of Liability Driven Investing (LDI) under Asset Liability Management (ALM) process is to match the duration of the liabilities with the assets so any change in the liabilities due to interest rates is offset by change in the assets. • Asset allocation to bonds– Invest in fixed (long duration) bonds equaling the liability duration. • Interest rate swaps – enter into swaps positions with the duration equal to the desired hedge ratio • Dynamic allocation and hedging – most commonly used. Mixture of asset allocation and swaps based on the funded status

8. Typical U.S. Defined Benefit Pension portfolio Heavy on equity and debt. Not hedged appropriately A typical graph for the cash flow for an active defined benefit plan

9. ALM process • ALM process involves looking at various probable scenarios of assets and liabilities in future in order to derive best investing strategy: • Generate future economic scenarios for all the asset classes and liabilities in the portfolio. Say stochastic scenarios • Model the assets and the liabilities based on the economic scenarios • Incorporate the contribution strategy • Incorporate the LDI strategies • Review all the strategies based on the risk report • Recommend asset mix and immunisation strategy to the investment committee

10. Generating scenarios – an overview • Generating economic scenarios is also called scenario analysis, stochastic simulation or Monte Carlo simulation and can be seen as a possible future evolution of all relevant uncertain macroeconomic variables. 2 • These stochastic simulations include bear and bull market conditions as well as normal market conditions. 2 • Random numbers are generated using Monte Carlo methods • Time series methods used are typically Auto regressive, lognormal auto regressive and normal random walk methods • Interest rates and credit spreads are typically modeled as lognormal processes • Equities and similar assets are modeled as normal random walk/ Brownian motions 2. Cornelis Slagmolen - Economic Scenarios for an Asset and Liability Management Study of a Pension Fund

11. Generating scenarios – examples Snapshot of simulated US equity Large Cap returns using normal random walk Simulated 1 YR US swap rates using Log Normal AR method

12. Projected Assets and Liabilities – a snapshot Simulated assets for a typical U.S. based pension fund Liabilities are calculated on mark to market value. Discounted on projected interest rates

13. Determining the best LDI Strategy • Although no “one size fits all” solution, there are few steps which can be followed after modeling the assets and liabilities: • Set a funded status goal based on the plan sponsors’ risk appetite • Identify the asset allocation mixes to range from highly risky portfolio to least risky portfolio. For example, starting with 100% invested in growth portfolio and doing 5% step decreases and allocate rest in the risk free portfolio • Perform asset/liability projections exercise for all the identified asset allocation mixes • Identify different rebalancing strategies to be considered in the model by performing iterations on all the asset allocation mixes. For example, dynamic rebalancing based on the portfolio funding level. • Incorporate swaps in the portfolio to determine the best hedge ratio • Prepare a risk/reward chart for all the asset allocations and rebalancing strategies • Identify the most appropriate asset allocation strategy and asset mix based on the results for the last projected year given the level of risk.

14. Questions?

15. About the Author Vineet Hanshas been working as an actuarial analyst for U.S. based Defined Benefit Pension Plans for more than 6 years. He started his career with the liability valuations. He currently leads a team in CRISIL which is involved in validating a DB pension risk model and providing consulting for further enhancements. He has completed his bachelors in Mathematics (honors) from University of Delhi He has also been involved in leading the efforts to create in-house DB Pension ALM tool. He is a student actuary with Institute of Actuaries of India. When he is not crunching numbers, he is cycling, playing football or just any sport. Contact: Vineet.hans@crisil.com