Risk Management: Foundations for a Changing Financial World

CHAPTER 53

LIABILITY-DRIVEN INVESTMENT STRATEGIES FOR PENSION FUNDS^ba

Roman von Ah

For many years, pension fund management focused exclusively on managing the assets of the plan. The “perfect storm” that occurred at the beginning of this decade, however, caused asset values to decline as liabilities soared and triggered a steep decline in the funded status of pension funds globally. This experience fostered the development of liability-driven investing—the recognition that pension fund assets should be chosen to match the behavior of a fund’s liabilities.

If I am managing institutional money for pension funds, it makes a lot of sense for me to understand the pension fund’s ultimate purpose. Pension fund managers are looking for answers from the asset management side to be able to provide pensions 20, 30, or 40 years down the road. The asset management side can talk about alpha, beta, dynamic allocation, and so on, but it tends to neglect the fact that its ultimate purpose is to provide enough assets to pay for liabilities decades in the future. The world of liability-driven investments (LDI) is a useful paradigm to broaden the overall investment perspective and enhance the solution space for securing payments far in the future.

Before discussing LDI, I will give you some insight into the Swiss pension system. Then, I will review the traditional approach to asset allocation, mean-variance optimization, and surplus optimization, which leads quite naturally into the field of LDI. ...