Executive Summary
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Asset liability management (ALM) is an overall risk management technique for pension funds.
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ALM requires the board to formulate guidelines for its strategy on contribution and indexing levels, and its attitude to risk.
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ALM is based on stochastic simulation and is used as a basis for decisions on the distribution of future contributions, funding, and indexing levels.
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Practicing ALM requires an assets and liabilities committee (ALCO). An ALCO consists of senior pension fund management, with the chief risk officer as chairman. The committee converts the guidelines into formal proposals on the investment strategy and the contributions and indexing policies.
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ALM does not predict the future, but it gives insight into the possible risks a pension fund is exposed to and how to handle them.
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An ALM model should be as parsimonious and uncomplicated as possible. The purpose of such models is to act as a tool to help management understand what is really going on, and how to reach responsible and internally consistent decisions.
Introduction
The management of a pension fund has to make decisions about its strategic asset allocation, its contributions policy, and its indexing policy in a context of acceptable financial risk. It has to meet the return requirements necessary to improve benefit payments on the one hand, and to stay in line with the solvency requirements of the regulator on the other. But what is an acceptable contributions and indexing policy, and how is an acceptable risk attitude defined? ALM forces the board to think about these aspects, and to quantify them. That is not an easy job. But only by giving clear guidelines does risk management have practical and measurable value. Putting ALM into practice is not a solo achievement but requires a multidisciplinary team of specialists who are willing to work together. Formalization normally results in the so-called assets and liabilities committee, or ALCO, with the chief risk officer as chairman.
The Aim of ALM
A crucial stage in the exploration of an ALM strategy is the development of the funding level. The funding level is the ratio of the market value of the assets and the market value of the liabilities. Funding levels below 100% are disliked because the assets do not cover the total value of the liabilities. So management of the funding level in general, and the possibility of underfunding in particular, is of primary importance. Generating high funding levels is easy to accomplish. Just increasing the contributions and investing them in low-risk assets will generate attractive funding levels. However, neither employers nor employees will be too enthusiastic about this solution because they are faced with high pension contributions.
Another important concern is the indexing policy. Pension funds aim to index their benefit payments based on the price inflation of the previous year to protect pensioners from loss of purchasing power. Such indexing clauses are conditional, as full indexing can only be implemented if the funding level is high enough. The closer the funding level falls to the 100% mark, the less the benefits will be increased. If benefit payments are to be made inflation-resistant, adequate indexing levels are very important.
ALM, therefore, is the search for a balanced perspective. By practicing ALM we want to find a balance between future contributions on the one hand and future funding and indexing levels on the other. To accomplish this, the choice of strategic asset allocation plays an important role, as Figure 1 shows.
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