Training 2 Hari Penerapan SPERIS dan SANBERRIS Dana Pensiun · Penerapan SPERIS dan SANBERRIS Dana Pensiun 4 SECTION 2 u ALM is the practice of managing business so that decisions

ASOSIASI KONSULTAN AKTUARIA INDONESIA

TrainingTraining 2 2 HariHariPenerapanPenerapan SPERIS SPERIS dandan SANBERRISSANBERRIS

Dana Dana PensiunPensiun

AssetAsset--Liability ManagementLiability Management::An IntroductionAn Introduction

Redtop Hotel, Jakarta, Juni 2008 – April 2009

22Penerapan SPERIS dan SANBERRIS Dana Pensiun

ContentsContents

1212--1414Monte Carlo SimulationMonte Carlo Simulation55

1515--1818Steps to ALM ProcessSteps to ALM Process66

1919--2323Understanding Simple ModelUnderstanding Simple Model77

88--1111ALM for Pension FundsALM for Pension Funds44

77Role of ActuaryRole of Actuary33

2424--3838Basic MetricsBasic Metrics88

44--66What is ALM?What is ALM?22

33IntroductionIntroduction11

ContentsContents PagePageSectionSection


SECTION 1SECTION 1

u Corporate and individual financial systems are supported by a cash flow balancing (matching) activitiesn Savings for child education: savings are assets to be invested and

future payment of school fees are liabilitiesn Pension plan: contributions are assets invested to meet pension

payments (liabilities) at future dates

u Matching activities of cash flows of financial planning is called Asset-Liability Management (ALM)

GeneralGeneral

IntroductionIntroduction


SECTION 2SECTION 2

u ALM is the practice of managing business so that decisions taken with respect to assets and liabilities are coordinated

u ALM can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve financial objectives, giventhe risk tolerance and other constraints

u Traditional ALM focuses primarily on the risks associated with changes in interest raten Current ALM considers much broader range of risks: equity,

liquidity, currency and sovereign/country

GeneralGeneral

What is ALM?What is ALM?


SECTION 2 SECTION 2 (continued)

u Discrepancies between assets and liabilities do exist when volume and timing are concernedn Some assets may be short term but liabilities are long term

u Perfect match is not always possible

GeneralGeneral




u Application of ALM techniques in diverse setingsn Derivative dealers manage their long and short positionsn Bankers coordinate the repricing horizons of their assets and liabilitiesn Pension plans adjust their investments to mirror the characteristivs of

their liabilities with respect to interest rates, equity returns and expected changes in wages

n Insurers select investment strategies to ensure they can suportcompetitive pricing and interest crediting strategies

ApplicationApplication



SECTION 3SECTION 3

u Actuaries measure, model and manage risk

u Actuaries must have knowledge and understanding of assets and liabilities and how they are interrelatedn The operation of financial marketsn The available instrumentsn The risks inherent in any particular business to enhance profitability and

solvency

u The coordination of product development, investment operations and financial reporting is essential for a succesful financial security systemn Actuaries are well prepared through education and experience to perform

this role

Role of ActuaryRole of Actuary


SECTION 4SECTION 4

u ALM for pension funds is a risk management approachn Takes into account assets, liabilities, interaction between different

policies to apply

u Board should find acceptable policies that guarantee that the solvency of the fund is sufficient during the planning horizon and at the same time all promised benefit payments will be made

u Solvency is the ability to fulfill all promised payments in the long runn Solvency at a certain time moment is measured as the funding ratio

u Funding ratio changes over time – fluctuations in the liabilities and assets – controlled by rebalancing asset portfolio and adjusting contributions

GeneralGeneral

ALM for Pension FundsALM for Pension Funds



u Conflicting interests of different parties exist in ALM decisionprocess

u At least 5 parties are involved in the decision making processn Active participantsn Retired persons and surviving relativesn Deferred membersn Sponsor of the fundn Supervisor of the fund

Interested parties in the policy of pension fundInterested parties in the policy of pension fund




u Instruments to control funding ratio by taking into account the interested parties to obatain best policy mixn Pension policy – different types of pensions includedn Pension system – rules with respect to benefit paymentsn Indexing policy – consumer price index or a wage indexn Reinsurance policy – risks of decease or disabilityn Contribution policy – dynamic and can be changed over timen Investment policy – decision of assets classes, limitation in each assets

classes

Policies and Policies and intrumentsintruments




u Pension funds are exposed to many sources of risksn Funding ratio is important in determining the financial soundness of a

fund and the greatest concerns is the risk of underfunding: the risk that the value of the liabilitiesis higher than the value of the assets

u Some of the many sources of risksn Risks regarding the asset portfolio – currency, default, volatilityn Actuarial risks – longevity risk, risk of short life, economic assumptionsn Risks with respect to contributions – contractual contributions need to be

paid when sponsor are in bad financial situationn Risks regarding reinsurance – risks of defaultn Risks with respect of indexing

u Risks may be reduced – broadly diversified portfolio for example

RisksRisks



SECTION 5SECTION 5

u Methodology created by Stanislaw Ulamn A scientist who worked on the Manhattan Project – forecasting possible

ranges and impacts of nuclear explosionsn Named after his uncle who liked to gamble at Monte Carlo

u Monte Carlo Simulationsn Describe range of investment results with a given investment allocationn Show the probability of achieving successful and unseccesful outcomesn Use randomly generated returns based on a protfolio’s risk and return

profile (historical or estimated standard deviation and expected return) to calculated thousands of potential portfolio values over a given period and sum all the probability of any of those outcomes

GeneralGeneral

Monte Carlo SimulationMonte Carlo Simulation



u Monte Carlo Simulations include 3 critical factors that linear forecating may ignoren Compoundingn Cash flown Sequence of returns

u Compoundingn Linear forecasting uses arithmetic returns which ignores the effect of

compounding – uses simple averagen Geometric returns take into account of compoundingn See example

Critical factorsCritical factors




u Cash flown Average approach ignores the impact of cash flows in and out of a

portfolio – uses time-weighted rate-of-return (TWR) or “investment return”– ignores the impact created by the inflow of new money

n Instead uses dollar-weighted rate of return (DWR) or “investor return” –takes into account the timing of contributions and withdrawals

u Sequence of returnsn Sequence of returns may effect investorsn The order in which an investor encounters returns over time has a direct

effect on the terminal value of the portfolio

Critical factorsCritical factors



SECTION 6SECTION 6

u An effective ALM process begins with the support of the managementn On going communication is essential

u The process consists of 5 fundamental stepsn Assess risk/reward objectivesn Identify risksn Quantify level of risk exposuren Formulate and implement strategies to modify existing risksn Monitor risk exposure and revise strategies as appropriate – continual

process

Fundamental stepsFundamental steps

Steps of ALM ProcessSteps of ALM Process



u Assess risk/reward objectivesn Not necessarily to eliminate or even minimize riskn The level of risk will vary with the return requirements and objectivesn Determine objectives and risk tolerances and review from time to time

u Identify risksn Must identify all sources of risks for all assets and liabilitiesn Risks are broken down into their component pieces and the underlying

causes of each component are assessedn Relationship of various risks to each other and or to external factors are

also identified





u Quantify level of risks exposuren Relative to changes in the component piecesn As a maximum expected loss for a given confidence interval in a given

set of scenariosn The distribution of outcomes for a given set of simulated scenarios for the

component piece over timen Regular measurement and monitoring of the risk exposure is required

u Formulate and implement strategies to modify existing risksn Mitigating risks by modifying existing risks through techniques such as

diversification and porfolio rebalancingn Optimization of the risk/reward tradeoff – tolerance, opportunities and

constraintsn Professional judgment is an important part of the process





u Monitor risk exposure and revise strategies as appropriaten All identified risk exposure are monitored and reported on a regular basisn If a risk exposure exceeds its approved limit, corrective actions are taken

to reduce the risk exposuren Monitoring current financial status and possible short-term outcomes is

very helpful in managing pension riskn Operating within a dynamic environment

w Risk tolerances and financial objective change – existing strategies may no longer be appropriate

w Strategies need to be periodically reviewed and modifiedw Formal documentation of communication process is particularly important




SECTION 7SECTION 7

Understanding Simple ModelUnderstanding Simple Model

ExampleExample




IRR and standard deviationIRR and standard deviation




IRR and standard deviationIRR and standard deviation




SolventSolvent




SolventSolvent


SECTION 8SECTION 8

Basic MetricsBasic Metrics



u Price of Bond =n Coupon x Annuity Factor (r, T) + Par Value x PV Factor (r, T)n Annuity Factor (r, T) = {(1 – V^T) / r}n PV Factor = V^T = (1+ r) -̂T

u For example, an 8% coupon, 30-year maturity bond with par value of 1,000 paying 30 annual couponsn T = 30n Coupon = 80n r = 8% per annum – interest rate = coupon rate

Bond pricingBond pricing




u Value of bondn 80 x Annuity Factor (8%, 30) + 1,000 x PV Factor (8%, 30)n 80 x 11.25778334 + 1,000 x 0.099377333n 900.6226672 + 99.37733254n 1,000

u In this example, the coupon rate equal to the market interest rate and the bond price equals par value

u If the interest rate were not equal to the bond’s coupon rate, the bond would not sell at par value





u For example, if the interest rate were to rise to 10% per annum, the bond’s price would fall by 188.54 to 811.46n 80 x Annuity Factor (10%, 30) + 1,000 x PV Factor (10%, 30)n 80 x 9.426924467 + 1,000 x 0.057308553n 754.1539574 + 57.30855300n 811.46…

u At a higher interest rate, the present value of the payments to be received by the bond-holder is lowern Bond price will fall as market interest rates risen This is crucial general rule in bond valuation





Bond pricing: more examplesBond pricing: more examples




Maturity model: more examplesMaturity model: more examples




u Duration is a key concept in fixed-income portfolio management for at least 3 reasonsn It is a simple summary statistic of the effective average maturity of the

portfolion It turns out to be an essential tool in immunizing portfolios from interest

rate riskn It is a measure of the interest rate sensitivity of a portfolio

u Because the relationship between maturity and the interest rate,the longer the term to maturity on a fixed income investment, the more sensitive is the value of that investment to any interest rate change, keeping everything else constant

DurationDuration




u It computes the present value weighted (discounted with interest) average time to maturity of the cash flows of a certain financial instrument

u Duration method is more appropriate than a maturity method to measure interest rate risk because it not only takes into account the maturity but also the timing of the cash flows of the instrument or portfolio exposed to interest rate riskn It measures the “average life” of the asset or liability

MacaulayMacaulay’’s durations duration




MacaulayMacaulay’’s durations duration




u Modified duration of financial instruments is a measure of pricesensitivity of a fixed set of cash flows to small changes in the single interest rate

u This statistic captures how small changes in the interest rate will affect changes in the price and is expressed as a percentage

u It is equal to Macaulay’s duration divided by one plus its effective annual yield to maturity

Modified durationModified duration




u An insurance company issues a guaranteed investment contractn Contract for 10,000n Has a 5-year maturityn Guaranteed interest rate of 8%

u Obligation of insurance isn 10,000 x (1.08) ^ 5n 14,693.28 in 5 years

u Suppose the insurance company funds its obligation with 10,000 of 8% annual coupon bonds, selling at par value with 6 years to maturity

Example of insurance contractExample of insurance contract




u As long as the market interest rate stays at 8%, the company hasfully funded the obligation, as the present value of the obligation exactly equals to the value of the bonds

u If interest rates rise, the fund will suffer capital loss, impairing the ability to satisfy the obligation

u However, at a higher interest rate, reinvested coupons will grow at a faster rate, offsetting the capital loss

u Increases in interest rates cause capital loss but at the same time increase the rate at which reinvested income will grow









u When the portfolio duration is set equal to the horizon date, the accumulated value of the investment fund at the horizon date will be unaffected by interest rate fluctuations – immunization

u Immunization seeks to match interest rate sensitivities of assets and liabilities

u See example on duration mismatched




End of presentationEnd of presentation

Training 2 Hari Penerapan SPERIS dan SANBERRIS Dana Pensiun · Penerapan SPERIS dan SANBERRIS Dana Pensiun 4 SECTION 2 u ALM is the practice of managing business so that decisions

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