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ALM and Asset Allocation Solutions

Managing Pension Assets: from Surplus Optimization to Liability Driven Investment

In this paper, we consider an intertemporal portfolio problem in the presence of liability constraints. Using the value of the liability portfolio as a natural numeraire, we find that the solution to this problem involves a three fund separation theorem that provides formal justification to some recent so-called liability-driven investment solutions offered by several investment banks and asset management firms, which are based on investment in two underlying building blocks (in addition to the risk-free asset), the standard optimal growth portfolio and a liability hedging portfolio.

Recent difficulties have drawn attention to the risk management practices of institutional investors in general and defined benefit pension plans in particular. What has been labeled “a perfect storm” of adverse market conditions over the past three years has devastated many corporate defined benefit pension plans. Negative equity market returns have eroded plan assets at the same time as declining interest rates have increased market-to-market value of benefit obligations and contributions. In extreme cases, this has left corporate pension plans with funding gaps as large as or larger than the market capitalization of the plan sponsor. For example, in 2003, the companies included in the S&P 500 and the FTSE 100 index faced a cumulative deficit of $225 billion and £55 billion, respectively (Credit Suisse First Boston (2003) and Standard Life Investments (2003)), while the worldwide deficit reached an estimated 1,500 to 2,000 billion USD (Watson Wyatt (2003)).

That institutional investors in general and pension funds in particular have been so dramatically affected by recent market downturns has emphasized the weakness of risk management practices. In particular, it has been argued that the kinds of asset allocation strategies implemented in practice, which used to be heavily skewed towards equities in the absence of any protection with respect to their downside risk, were not consistent with a sound liability risk management process.

In this context, new approaches that are referred to as liability driven investment ("LDI") solutions have rapidly gained interest with pension funds, insurance companies, and investment consultants alike, following recent changes in accounting standards and regulations that have led to an increased focus on liability risk management. While their promoters argue that such LDI strategies can add significant value in terms of liability risk management, their benefits from a rational standpoint have not been documented in the academic literature and a significant number of institutional investors are still reluctant to use them.

The aim of this paper is to provide an academic perspective on asset-liability management (ALM) strategies. In particular, we introduce a formal continuous-time model of intertemporal asset allocation decisions in the presence of liability constraints, and discuss how recent industry trends such as liability-driven investment fit with respect to the theoretical optimally designed strategies. The rest of the paper is organized as follows. In section 2, we provide a brief history of ALM techniques, outlining both the practitioner and the academic standpoints. In section 3, we introduce a formal model of asset-liability management. In section 4, we present a conclusion.