ALM for Pension funds demystified

G.R. Nagendran

Introduction
ALM is concerned with making all promised payments at minimum costs. The issues relating to ALM gain more importance in the light of declining interest rates world over. While the pension funds have to maintain the security and confidence it is e!ually important to o"serve transparent retired life. A pension funds has to match the portfolio of long%term lia"ilities with the portfolio of assets. &ey issues in strategic asset Lia"ility management 'ALM( are the ad)ustments of the contri"ution rate of the sponsor and the reallocation of the investments in several asset classes at various points of time. This paper attempts to list out the issues faced "y the pension funds in the field of the ALM and discusses how these risks could "e shared "etween various participants and also "riefly "rings out the role of an econometric model. 1.0 present scenario of Indian pension market procedure so as to enhance confidence in customers#contri"utors$ mind. pension products assume a dignified

the passage of the *R+A ,ill led to the li"erali-ation of the *ndian insurance industry. ,ut the government is yet to decide a"out the pension sector reforms. .nly "e choosing a suita"le pension plan one can dream to retire with silver in the hair and gold in the pocket. *n *ndian interest rates were e/periencing an upward movement

during the past few decades leading to the preference of the short% term investment in financial institutions post%offices "anks etc. it was

natural that the common people were e/pecting the continuation of the same trend. 0owever an opposite trend has emerged with the li"erali-ation that reversed the e/pectation of the masses. The factors responsi"le for the slow growth of the *ndian pension market are1 a( Non%availa"ility of suita"le long%germ financial instruments offering reasona"le return at an accepta"le level of risk. "( 2rosion of purchasing power due to high inflation rate resulting in discouraging of savings. c( *nade!uate amount of contri"ution pension "enefit of their employees The fund managers should ma/imi-e the return on investment with active portfolio management. The Government should make attempts to channelise the saving for "uilding infrastructure developing de"t markets and sta"ili-ing the capital markets. 2.1 Meaning and Objectives of ALM A pension fund has the task of making "enefit payments to participants who have crossed their active income%earning career. 3ension fund has three sources of funding its lia"ilities1 revenues from its asset portfolio regular contri"utions made "y the sponsor of the fund and remedial contri"utions made "y the sponsor. The latter payments may "e called for if the value of the assets is too low compared to the value of the lia"ilities. The pension fund has to decide periodically how to distri"ute the investments over different asset classes and what the contri"ution rate should "e in order to meet all its o"ligations. This decision process is called 4Asset Lia"ility Management$ 'ALM( The goal of the ALM process is to ena"le payment of current and future pensions. A pension fund has long%term o"ligations up to decades and therefore its planning hori-on is too large. The main goal of ALM is to "y employers against the

find

accepta"le

investment

and

contri"ution

policies.

Which

guarantees the sufficiency of solvency of the fund during the planning hori-on. 5.5 o!e of ALM in Pension funds

*dentification of various risks is very important in the field of pension funds management with special reference to ALM. They include the following1 a( 6inancial ,ankruptcy 7this is a risk of solvency as the value of assets are less than that of lia"ilities. "( 6raudulent "ankruptcy%this is a kind of operational risk maintaining the arms length relationship "etween which the

results from "ad management and lack of internal controls and not administrators of pension fund and employer. c( *nflation risk%this is a king of economic risk where the purchasing power of pension is completely eroded due to high inflation. d( 8hort term market risk emanates from low interest rate scenarios which reduces the income from assets and threaten the "alance sheet values. e( Long term market risk is one like 9:5: financial crisis in markets which took more than 5; years to recover to the earlier level. f( Longevity risk are due to improvement in life e/pectancy. g( Wage evolution risks "ased on wage level changes or even in the case of pay as you go scheme. 5.< ALM issues in pension "ector Asset lia"ility management has assumed grater importance for pension funds due to the following factors1

a( Necessity1 the revenue of pension fund is no more a small portion for the household "ut it is a necessary component of the "udget "ecause people after retirement need regular money for the health protection. "( +uration1 ALM is a key point for pension funds "ecause of duration. c( =arying profiles1 pension funds have to manage very different profiles. Long duration uncertainty of life e/pectancy heterogeneity of contri:"ution "etween mem"ers differences of "ehavior at the age of retirement etc. Mathematical reserves contri"utions and "enefits aren$t as predicta"le )ust like simple endowment or money "ank products. ALM has to "e a very serious matter to secure the scheme whatever "e the profile of the accumulation period and "enefit period. All the risks to "e identified are real and pose considera"le threat to pensioners$ confidence. 0ence attempt should "e made to identify control and mitigate them. transfer of risk is an important segment in the Actuarial control >ycle. These mitigation techni!ues are suggesting ways to share them "etween state insured and insurance company in a very transparent company in a very transparent way. Minimal funding consisting should "e planned consisting of

contri"utions "y active participants of the fund and the sponsor 'e.g. the company "acking the fund( and su")ect to lows and rules specified "y the regulating authority for pension funds. *n addition the outcome should to conform to the long%term policy rules of the pension fund. The strategic Asset lia"ility Management 'ALM( pro"lem for pension funds is a dynamic decision pro"lem under uncertainty. Management of assets involves decision of the strategic portfolio mi/ and the lia"ilities which consist of future pension payments depend on inde/ action policies. +ue to long time hori-on over which the lia"ilities

range normally of <? years the pro"lem is inherently dynamic. Again uncertainty plays a ma)or role. A typical e/ample may "e that asset investments yield unknown pay%off and valuation of future lia"ilities at market value.

2.# ALM Mis$Matc% *n any investment game the fund manager must select the assets in such a way as to meet the lia"ilities properly. ,ut asset%lia"ility mismatch is !uite common in the management of the pension and gratuity due to the following reasons1 a( +uration of lia"ilities ranges "etween <? and @? years while the general tenure of the availa"le assets is limited to 5? years. R,* issued <? years. G.* papers for the first time only during August 5??5. "( Lack of knowledge of the pension and provident fund managers on the employee demographics 5.; ALM for pension funds vis$&$vis 'inancia! Institutions ALM is very important is the case of uniti-ed pension funds 'defined contri"ution( "ecause in these schemes the risks are transferred to the mem"ers. 8ince they don$t have the capital of pension fund and they are less financially educated than insurance >ompany a tailor made ALM adapted to suit their profile should "e proposed to them. Many plan sponsors are "eginning to convince the actuarial world with the capital market side of the "usiness "y reviewing their true economic risk as the risk to the pension surplus. They can then analy-e pension lia"ilities as a portfolio of -ero coupon "onds making the fund$s ALM process analogous to that of a "ank or an insurance company. ALM for pension funds differs from ALM for financial institutions in that it may re!uire less fi/ed income immuni-ation and more e!uity%like investment to match the varia"ility of the uncertainty in lia"ility pro)ections. 8till the principles that commercial and investment "anks use to allocate risk ad)usted capital daily may "e applies to monthly pension fund "enchmarkin as well.

<.? "%ortcomings of e(isting pension sc%emes All the pension and social security schemes altogether cover a very small pie of the total num"er of working *ndians from the organi-ed sector ad have the following disadvantagesA a( While investments and pension withdrawals en)oy ta/ "enefits pension incomes are treated as ta/a"le income and ta/ed "( 8avings is meager for meeting contingencies due to high

contri"ution level c( 8tipulation off. d( Neglect of actuarial valuation for contri"utions and insufficiency of returns in meeting pension o"ligations. e( 3oor !uality of administration and governance of the funds and high e/penses f( Low level of "enefits in many cases. g( *ncreased longevity due to improvements in healthcare systems h( 2mergence of nuclear family system due to mo"ility of the people i( ,etter education and health standards elongating the life of old people. #.1 Prudent investment norms and corporate )overnance corporate head!uarters are "ecoming increasingly involved in the management of all of their pension plan assets around the world. Reasons often heard cited for this heightened focus include1 a( Lack of focus of the financial impact on the group "( *nconsistency of returns worldwide of passive portfolio management strategies with

stringent norms leaving no fle/i"ilities in suita"le risk%return trade%

c( Lack of ade!uate resources "eing applied at local level d( A need for "etter information a"out the plans and risks of running with "etter cost management ad control e( 6ailure to take advantage of the group$s glo"al economies of scale. Achieving a change in the asset allocation process re!uires

considera"ly full attention of management rather than changing the investment profile and often re!uires more people skills than financial skills. The constant monitoring of maintaining solvency margins and prudent investment policy would result in adoption of correct corporate governance practices. The important guidelines towards governance structure and governance mechanisms are1 a( Appropriate legal and governance structure to ensure that funds are managed in the interest of plan mem"ers "( Accounta"ility integrity and professionalism of individuals on fund$s governing "ody c( Transparency and rules for communication "etween fund managers and plan mem"ers d( Actuarial certification independent auditing and the role of "oth actuaries and auditors. #.2 investment issues in management of pension funds prudent investment norms are already notified to further enhance the financial flesi"ility and risk management a"ility of insurers and for "etter management of investment portfolios. Maintenance of operational sta"ility would pose a challenge in the days to come with increase in e/posure and financial comple/ity due to glo"alisation. As a result prudent investment management would "ecome increasingly critical to insurers in their operations. The e/pected guidelines on related party transactions to ensure management integrity and pu"lic

accounta"ility in the conduct of insurance would reinforce the fiduciary duty owed "y insurers to properly manage insurance funds in an independent and transparent manner for the interest of policyholders at all times. #.* adoption of best investment practices the "est investment management should "e targeted through cost reduction and strong asset management. The specific focus should "e to earn the returns compara"le to other financial instruments. the investment management. 3ension and gratuity funds in *ndianshould follow prudent under writing practices and should target for reduction of administration e/penses. 6ollowing the "est investment practices and ensuring a strong Asset management company to ma/imi-e returns would greatly contri"ute in "etter management of investments. +.0 pre$re,uisites for pension reforms imp!ementation for the effective implementation of the pension reforms the following measures should "e taken1 a( Advocacy and education on pension re!uirements among the common people and policy makers "( Availa"ility of suita"le financial assets offering reasona"le returns at an accepta"le level of risk c( >onfidence amongst customers for early detection and proper compen%sation against and fraud d( 6ormulation of the investment principles development of prudential norms regarding the safety of the funds and the profita"ility of the operations e( 3rotection of interest of "eneficiaries f( 3romise for efficient services and the mechanism for redressal of grievances at the earliest possi"le

g( 8cope for healthy competition of players at different segments of the market h( 8pecification of limit of e/penses for administration and

management of funds i( 8uita"le ta/ incentives for the growth and development of the *ndian pension market "y encouraging the individuals as well as the employers. -.1 .ifferent /ays to s%are t%e risks bet/een insured and pension funds there are many ways to structure the risk and profit sharing "etween 8tate pension funds and insured people. *t depends on the organi-ation on the lia"ility side on the assets side the capital and the management. a0 1ake care about peop!e2s e(pectation Most of the mem"ers are non%technical and hence they cannot appreciate this king of pure performance in de/ and assets volatility. They are more concerned with risk concept like pro"a"ility of the fund to "e under funded at least once in the ne/t 5? years. They are more concerned "y performance concept like for e/ample evolution of future annuities compared to inflation b0 "ecurity ad confidence *n case of a product with a high promise insurers have to secure the scheme and keep insurers$s confidence in taking low technical rates.