In recent years, both asset management (AM) and asset and liability management techniques (ALM) have experienced marked changes. In particular; modern ALM, or liability-driven investing, involves developing state-dependent asset allocation, the aim of which is to control risk and ensure that minimum funding ratios are respected at all times.

But how do European pension funds define investment policy? How is it implemented? How are contributions to the financial results analysed? The aim of the survey is to compare industry practices and the academic state of the art:

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The academic literature has amply demonstrated the importance of asset allocation in the performance of pension funds. The findings of Brinson, Hood and Beebower (1986)¹ that more than 90% of the average time-variation in returns is explained by strategic asset allocation has led to wide recognition of the importance of asset allocation in institutional investors’ returns and, by extension, in pension fund performance.

Since this study, asset management (AM) and asset and liability management (ALM) techniques have undergone marked changes:

• Institutions now typically allocate a significant proportion of their portfolios to alternative asset classes, such as listed and unlisted real estate, commodities, infrastructure and hedge funds.
• Stricter regulations and accounting standards have led to the development of asset liability management (ALM) techniques. These formally embed liabilities in the asset allocation decision. Modern ALM techniques also focus on risk control through state-dependent asset allocation whose aim is to ensure that minimum funding constraints are respected.

The first section of the survey attempts to assess how pension funds determine their asset allocations and how they embed and manage regulatory constraints (minimum funding constraints, discount rates, surplus volatility). We ask two types of questions:

• Questions to determine where, on the continuum between historical fixed-weight or buy-and hold asset allocation and more modern ALM techniques (which involve the definition of liability-hedging and performance-seeking portfolios), current pension fund practices stand
• Additional questions on whether regulatory constraints (minimum funding constraints, discount rates) are factored in and if so how.

The second section will allow us to understand what instruments are used in the implementation of the ALM strategy: we will identify the asset classes and structures that are used in investing. Answers to this question are essential for an understanding of the actual use of available asset classes by pension funds, and of the use of derivatives and structured products.

In the third section, we review risk management practices. We review methodology (for risk measurement), organisation (of the monitoring of risk), and techniques (limit setting):

• We attempt to determine whether pension funds use state-of-the-art methods to measure risk. Questions review both measures used (e.g. shortfall and its probability, Value at Risk) and aggregation methods used to assess the overall level of risk in pension funds.
• The first problem with risk management is generally perceived as organisational, with the risk management function necessarily independent of that of performance generation. The second problem has more to do with techniques.

The fourth and final section of the survey deals with the measurement of performance. Reviewing the performance of fund managers is now standard practice in the pension fund and consulting industries. Here, we also ask respondents to identify the methods they use to evaluate the performance of the investment policies defined by ALM departments.

Like previous EDHEC surveys of industry practices, this survey will attempt to assess the use of modern investment management techniques by pension funds. However, its focus is on ALM. The survey will assess how European pension funds define their investment policy, how they implement it, and how the performance of the investment policy is analysed.

In the area of risk management, our survey will focus on the two major components: techniques and organisation. The survey should thus allow pension fund managers to compare their strategies, techniques and organisation with those of their peers; it should also make it possible to measure gaps, if any, between actual practices and best practices.

No representative overview of the ALM practices of pension funds is currently available, since most surveys mainly review the current asset holdings of pension funds. We hope to shed light not only on the conception of the ALM strategy but also on its implementation, thereby encouraging dialogue between research and industry.

Reference

¹ Brinson, Gary P., L. Randolph Hood and Gilbert L. Beebower. 1986. Determinants of portfolio performance. Financial Analysts Journal, July-August, pp. 39-44.