ASSET MANAGEMENT ALM FRAMEWORK

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ASSET MANAGEMENT

within an

ALM FRAMEWORK

LE MÉRIDIEN SINGAPORE SEPTEMBER 6 – 7, 2007

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Focus on asset returns

Assets managed against benchmark

– Asset-only benchmark – Liability-driven benchmark

Investment (i.e. asset-only) objectives specified by client

Beating benchmark and/or achieving investment objectives does not

necessarily mean financial objectives will be met

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2 (80,000) (70,000) (60,000) (50,000) (40,000) (30,000) (20,000) (10,000) -2006 2011 2016 2021 2026 2031 2036 2041 2046 2051 2056 2061 2066 2071 2076 2081

Pension Plan Liability Cash Flows

Duration = 15.4 years

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Asset – Only Asset – Liability

Focus on asset only return / pure asset performance

Does not capture risk exposure

Asset mix determined using efficient frontier

Maximize risk-return trade-off to liabilities

Risk relative to liabilities more clearly defined

Risk to solvency ratios reduced Liability-Driven Investment (“LDI”)

Approaches Traditional Approach to

Pension Investment

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Strategic asset allocation and selection of benchmark are the major

sources of returns and risk

– value added by asset manager against benchmark is lower order of magnitude

Investment strategy loosely recognizes risks associated with pension

liabilities

– investment objective is to maximize expected return for a given amount of risk

– equities viewed as a good hedge against inflation, expected to outperform bonds in the long term

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E[R]

σ

SAA determined using efficient frontier analysis

Minimize risk for a given level of

expected return

Maximize expected return for a

given level of risk

Based on expected return,

standard deviation and correlation

between asset classes

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Good asset manager can add value vs. benchmark:

Credit quality assessment capabilities based on fundamental analysis

Tactical asset allocation

Interest rate anticipation strategies

Other yield enhancement strategies

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Traditional approach for pensions uses asset-only benchmark

Benchmarks include

– market indices • Lehman Aggregate • S&P500 – peer performance • quartile performance

May include duration target

Focus is on total return of assets irrespective of performance of liabilities

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8 Benchmark Weight Index Performance Actual Performance Asset Manager Outperformance S&P500 60% 10% 11% 1%

Lehman Aggregate (5 yr duration) 40% 5% 6% 1%

Portfolio 100% 8% 9% 1%

Liabilities (15 yr duration) 6%

Solvency Ratio 103%

Asset-Only Benchmark Example:

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Asset-Only Benchmark Example:

Interest rates flatten – long term rates down 1%

Benchmark Weight Index Performance Actual Performance Asset Manager Outperformance S&P500 60% 10% 11% 1%

Lehman Aggregate (5 yr duration) 40% 5% 6% 1%

Portfolio 100% 8% 9% 1%

Liabilities (15 yr duration) 21%

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10 Funding Ratio - S&P 500 Pension Plans

60% 70% 80% 90% 100% 110% 120% 130% 140% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: Credit Suisse

Asset-only approach exposed

pension plans to significant

risk

Solvency deficits resulted

from falling interest rates and

stock prices (so-called

“Perfect Storm”)

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Pension crisis could have been avoided

Asset-only approach focused on achieving high asset returns irrespective

of liabilities

Asset-Liability approach focuses on achieving asset returns that match

returns of liabilities

1) increase in asset value greater than increase in liabilities and/or 2) decrease in asset value less than decrease in liabilities

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Liability-Driven Benchmark Example:

No change in interest rates

Benchmark Weight Index Performance Actual Performance Asset Manager Outperformance

S&P500 0% 10% N/A N/A

Replicating Portfolio (15 years) 100% 6% 7% 1%

Portfolio 100% 6% 7% 1%

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Liability-Driven Benchmark Example:

Interest rates flatten – long term rates down 1%

Benchmark Weight Index Performance Actual Performance Asset Manager Outperformance

S&P500 0% 10% N/A N/A

Replicating Portfolio (15 years) 100% 21% 22% 1%

Portfolio 100% 21% 22% 1%

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Liability-Driven Benchmark plus Beta Example:

No change in interest rates / equities +10%

Duration 30 yr Pooled Fund 50% 6% 7% 1%

Portfolio 100% 8% 9% 1%

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Liability-Driven Benchmark plus Beta Example:

Interest rates flatten / equities +10%

Duration 30 yr Pooled Fund 50% 36% 37% 1%

Portfolio 100% 23% 24% 1%

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Liability-Driven Benchmark plus Beta Example:

No change in interest rates / equities – 10%

Benchmark Weight Index Performance Actual Performance Asset Manager Outperformance S&P500 50% -10% -9% 1%

Duration 30 yr Pooled Fund 50% 6% 7% 1%

Portfolio 100% -2% -1% 1%

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Liability-Driven Benchmark plus Beta Example:

Interest rates flatten / equities – 10%

Benchmark Weight Index Performance Actual Performance Asset Manager Outperformance S&P500 50% -10% -9% 1%

Duration 30 yr Pooled Fund 50% 36% 37% 1%

Portfolio 100% 13% 14% 1%

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New developments focus on Liability-Driven approach

Greater focus on ALM due to financial losses

Global shift to marking-to-market of assets and liabilities

Regulatory pressure to accelerate funding of deficits

New instruments enabling effective risk management

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Liability Cash Flows

(60,000) (40,000) (20,000) -20,000 40,000 60,000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 2055 2060 2065 2070 2075 2080

Liability Cash Flows

substantial

reinvestment

rate risk

exposure

pre-funding problem

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Replicating Portfolio Benchmark

– benchmark is derived as portfolio of zero-coupon bonds that replicates the liabilities – does not work well in practice for long-term liability cash flows

• zero-coupon bonds do not exist at required maturities

Minimum Risk Portfolio Benchmark

– benchmark is derived from universe of available instruments that minimizes interest rate risk exposure

– similar to immunization strategy on a specified basis

• dollar duration, effective duration, partial duration, convexity, etc.

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Duration Matched

(200,000) (100,000) -100,000 200,000 300,000 400,000 2 006 2 011 2 016 2 021 2 026 2 031 2 036 2 041 2 046 2 051 2 056 2 061 2 066 2 071 2 076 2 081

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Economic surplus exposed to interest rate changes

Asset Cash Flows Liability Cash Flows Net Cash Flows Present Value 1,259,979 1,177,505 82,474 Duration 20.69 20.69 20.71 Dollar Duration 26,073,803 24,365,528 1,708,276 Convexity 520 573 (275)

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Interest rate risk exposure to non-parallel yield curve shifts

Partial Durations PARTIAL DURATION SENSITIVITY ANALYSIS

Asset Cash Flows Liability Cash Flows 1 month (0.00043) (0.00052) 3 month (0.00222) (0.00218) 6 month (0.01327) (0.00831) 1 year (0.05815) (0.03251) 2 year (0.08661) (0.07642) 3 year (0.27027) (0.19842) 5 year (0.46674) (0.37466) 7 year (0.27681) (0.48408) 10 year (0.43401) (0.52143) 15 year (0.78572) 0.46578 20 year 1.54432 2.23528 25 year 6.34456 2.75792 30 year 15.19911 16.93281 TOTAL 20.69376 20.69327 0 0 ₇ _{35 19 106} 145 -222 -69 1532 692 -4716 758 (5,000) (4,000) (3,000) (2,000) (1,000) -1,000 2,000 1M 3M 6M 1Y 2Y 3Y 5Y 7Y ₁₀Y ₁₅Y ₂₀Y ₂₅Y 3 0 Y

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Focus on financial objectives

– eliminate “bets” not being fairly compensated for taking

– find best risk/reward solution (first optimize on default-free basis)

Assets managed directly against liabilities

– eliminates basis risk associated with using a benchmark – aligns portfolio manager incentives

– difficult for most asset managers => requires sophisticated techniques – assets no longer separated => performance measurement not simple

No need for client to specify separate investment objectives or try to

determine appropriate benchmark

ALM drives asset management

Greatest chance of achieving overall financial objectives and reducing risk

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Overview of ALM implementation

Establish Conceptual Framework Define Objectives Assign Roles & Respons. Establish Process Customize Tools & Analytics Develop Risk Reporting Set Org. Structure Identify / Describe Risks Measure Risk Exposure Determine Risk Limits Benchmark Current Practices Board Approval Formulate Strategies

Conduct interviews with Senior Mgt & Key Staff

Get Buy-In / Establish Risk Management Culture Draft ALM Policy Statement and Procedure Manual

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Substantial value added through ALM

ALM Framework

– ALM conceptual framework defines

• financial objectives, risk tolerances and constraints • how risk is measured

• surplus management philosophy *** Critical to get this right ***

– ALM Policy Statement and Procedure Manual – sophisticated tools to manage exposure

Integrated with ERM

– framework for strategic decision making

– use to achieve financial goals/maximize value

• reduce risks not being compensated for simultaneously increase returns

ALM drives asset management

– shift focus from asset returns to overall financial objectives

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Assets managed directly against liabilities

– liability benchmarks replaced with actual liability cash flows

– liability-driven benchmarks such as minimum risk portfolio and replicating portfolio benchmarks are tools used to separate asset performance from ALM performance

• can be gamed

• absolve portfolio manager from responsibility for overall ALM results • value added against benchmark is incremental by nature

Disciplined process

– ALM strategies are formulated to achieve financial objectives – impact of trades on ALM results tested prior to execution

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Impact on financial objectives broken down by source

Bets are made explicit

– duration or rate anticipation – credit selection

– backing fixed income liabilities with non-fixed income assets

Value added by asset manager is transparent

Performance measurement is more meaningful but difficult to implement in

practice

Some companies feel that performance measurement of asset

management is less important than successful execution of ALM

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Questions?

Charles L. Gilbert, FSA, FCIA, CFA [email protected] www.nexusriskmanagement.com