Alternative decision models for liability-driven investment

Abstract

Traditional Asset and Liability Management (ALM) models have been recently recast as Liability-Driven Investment (LDI) models for making integrated finan-cial decisions in pension schemes investment: matching and outperforming liabilities. LDI has become extremely popular as the decision tool of choice for pension funds. The last decade experienced a fall in the equity markets, while bond yields reached low levels. The UK Accounting standard FRS17 (since 2001, replacing SSAP24) requires the assets to be measured by their market value and liabilities to be measured by a projected unit method and a discount rate reflecting the market yields then available on AA rated corporate bonds of appropriate currency and term. When these new regulations were introduced, liabilities became harder to meet. In the case of a deficit, the pension fund trustees and employers have to agree on extra contributions to fill the deficit within 10 years time. Furthermore, deficit or surplus has to be fully included on the balance sheet of the sponsoring company. In the Netherlands and the Nordic countries, LDI models have become established (see C. Dert, 1995 and Drijver, 2005); the United Kingdom, Italy and a few other European countries are close followers of this trend. Traditionally, assets and liabilities were con-sidered separate. In asset management, the aim was to maximize return for a given risk level. However, the matching of the liabilities was not taken into consideration. The main argument was that assets should be made to grow faster than liabilities. The modern integrated approach to LDI considers the cash flow streams for invested assets of fixed-income portfolios enhanced by interest rate swaps and in some cases of swaptions.