CIA Annual Meeting LOOKING BACK…focused on the future

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans Practical Issues Steve Bonnar Pierre Caron

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 2 Establishing financial objectives Limitations of “matching” portfolios Alternative asset classes to model Establishing financial objectives Limitations of “matching” portfolios Alternative asset classes to model

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 3 Establishing Financial Objectives

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 4 Establishing Financial Objectives Business time horizon Corporate goals Long term and short term Strategic and financial Differences among lines of business Establishing Financial Objectives Business time horizon Corporate goals Long term and short term Strategic and financial Differences among lines of business

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 5 Establishing Financial Objectives Key financial metrics Cash contributions Pension expense Other Establishing Financial Objectives Key financial metrics Cash contributions Pension expense Other

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 6 Establishing Financial Objectives Economic effects on the sponsor’s business Price inflation Change in bond yields Equity market results Currency risk Establishing Financial Objectives Economic effects on the sponsor’s business Price inflation Change in bond yields Equity market results Currency risk

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 7 Establishing Financial Objectives Optimal funded status What basis Within what tolerances Pain thresholds Risk/reward trade-offs Establishing Financial Objectives Optimal funded status What basis Within what tolerances Pain thresholds Risk/reward trade-offs

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 8 Limitations of “Matching” Portfolio

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 9 Limitations of “Matching” Portfolio Set of assets Most closely matches liability cash flows Default risk-free assets Similar duration Similar inflation sensitivity Limitations of “Matching” Portfolio Set of assets Most closely matches liability cash flows Default risk-free assets Similar duration Similar inflation sensitivity

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 10 Limitations of “Matching” Portfolio Hedging exactly is impossible Decrement risk Basis risk between price and wage inflation Liability measurement bases Limitations of “Matching” Portfolio Hedging exactly is impossible Decrement risk Basis risk between price and wage inflation Liability measurement bases

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 11 Limitations of “Matching” Portfolio Active liabilities look like mix of nominal and real bonds Typical pensioner liabilities look like nominal bonds Limitations of “Matching” Portfolio Active liabilities look like mix of nominal and real bonds Typical pensioner liabilities look like nominal bonds

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 12 Limitations of “Matching” Portfolio Purpose is to understand cost/benefit of accepting risk Generally not a rational investment policy Limitations of “Matching” Portfolio Purpose is to understand cost/benefit of accepting risk Generally not a rational investment policy

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 13 Limitations of “Matching” Portfolio Used as a relative measure and depends on Objective Valuation methodology May be multiple objectives Limitations of “Matching” Portfolio Used as a relative measure and depends on Objective Valuation methodology May be multiple objectives

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 14 Alternative Asset Classes to Model

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 15 Alternative Asset Classes to Model Two broad categories Return-enhancers Risk-diversifiers Critical issue Policy, strategic or tactical decision Is alternative a separate asset class? Alternative Asset Classes to Model Two broad categories Return-enhancers Risk-diversifiers Critical issue Policy, strategic or tactical decision Is alternative a separate asset class?

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 16 Alternative Asset Classes to Model Should it be modeled? Clear expectation of behaviour Sufficiently homogeneous Behaviour based on underlying asset Large sample with sufficient history Sufficient resources to select/monitor Alternative Asset Classes to Model Should it be modeled? Clear expectation of behaviour Sufficiently homogeneous Behaviour based on underlying asset Large sample with sufficient history Sufficient resources to select/monitor

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 17 Alternative Asset Classes to Model Need a reasonable commitment Less than 5% not meaningful 10+% allocation useful Liquidity must be appropriate Alternative Asset Classes to Model Need a reasonable commitment Less than 5% not meaningful 10+% allocation useful Liquidity must be appropriate

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 18 Establish financial objectives that reflect the sponsor’s business realities Use “matching” portfolio to assess risk/reward trade-offs Consider carefully which asset classes to model Establish financial objectives that reflect the sponsor’s business realities Use “matching” portfolio to assess risk/reward trade-offs Consider carefully which asset classes to model

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 19 Risk budgeting Extent of study Transport strategies Robustness of results Risk budgeting Extent of study Transport strategies Robustness of results

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 20 Risk Budgeting

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 21 Risk Budgeting Motivations :  Better understanding of risk/reward tradeoff relative to minimum risk position  Determination of whether risks taken are being compensated  Monitoring of experience vs expectations Risk Budgeting Motivations :  Better understanding of risk/reward tradeoff relative to minimum risk position  Determination of whether risks taken are being compensated  Monitoring of experience vs expectations

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 22 Risk budgeting Overview of concept :  Starts with determination of minimum risk portfolio (“matching” portfolio)  Determines the additional risk and return (reward) of given asset mix relative to minimum risk portfolio :  In total and by asset class  Risk expressed as volatility of financial situation of the plan Risk budgeting Overview of concept :  Starts with determination of minimum risk portfolio (“matching” portfolio)  Determines the additional risk and return (reward) of given asset mix relative to minimum risk portfolio :  In total and by asset class  Risk expressed as volatility of financial situation of the plan

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 23 Risk Budgeting Practical issues  Understanding by client of what the results mean  Make linkage with the sponsor’s key financial objectives and risk tolerance Risk Budgeting Practical issues  Understanding by client of what the results mean  Make linkage with the sponsor’s key financial objectives and risk tolerance

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 24 Extent of Study

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 25 Extent of Study Typically :  Allocation between equity/fixed income  Structure of fixed income portfolio  Allocation between Canadian/foreign equities But sponsors want more answers… Extent of Study Typically :  Allocation between equity/fixed income  Structure of fixed income portfolio  Allocation between Canadian/foreign equities But sponsors want more answers…

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 26 Extent of Study Potential overlap between asset allocation study and manager structure :  For example, small cap equities Treatment of alternative investments :  Separate asset class vs part of equity/fixed income Active management :  ALM studies are essentially always based on market indexes  But sponsors might be interested in active risk budgeting Extent of Study Potential overlap between asset allocation study and manager structure :  For example, small cap equities Treatment of alternative investments :  Separate asset class vs part of equity/fixed income Active management :  ALM studies are essentially always based on market indexes  But sponsors might be interested in active risk budgeting

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 27 Transport Strategies

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 28 Transport Strategies Motivations :  Separate the market risk (Beta) from the active risk (Alpha)  Control liability risk  Provide added value on asset classes where traditional active management tends to add little value (e.g. fixed income) Transport Strategies Motivations :  Separate the market risk (Beta) from the active risk (Alpha)  Control liability risk  Provide added value on asset classes where traditional active management tends to add little value (e.g. fixed income)

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 29 Transport Strategies Two main types : Alpha transport :  Overlay the added value from a given asset class/strategy (e.g. hedge funds) to a passively managed asset class. Beta transport :  Change the profile of a passively managed equity portfolio to a portfolio better matched to liabilities (e.g. long term bonds), while keeping the equity risk premium. Transport Strategies Two main types : Alpha transport :  Overlay the added value from a given asset class/strategy (e.g. hedge funds) to a passively managed asset class. Beta transport :  Change the profile of a passively managed equity portfolio to a portfolio better matched to liabilities (e.g. long term bonds), while keeping the equity risk premium.

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 30 Transport Strategies Practical issues :  Understanding of strategies by plan sponsor  Extensive use of derivatives (futures, swaps,…)  Sponsor’s willingness to be different  Implementation Transport Strategies Practical issues :  Understanding of strategies by plan sponsor  Extensive use of derivatives (futures, swaps,…)  Sponsor’s willingness to be different  Implementation

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 31 Robustness of Results

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 32 Robustness of Results Garbage in, garbage out ? Volatility assumptions capture a range of possible outcomes But models do not capture real catastrophic scenarios Robustness of Results Garbage in, garbage out ? Volatility assumptions capture a range of possible outcomes But models do not capture real catastrophic scenarios

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 33 Robustness of Results Need to supplement simulation process Two main possibilities :  Sensitivity analysis  Deterministic scenarios Robustness of Results Need to supplement simulation process Two main possibilities :  Sensitivity analysis  Deterministic scenarios

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 34 Robustness of Results Sensitivity analysis :  Perform stochastic simulations using different assumptions for certain key variables  Typical example would be to use different equity risk premium vs base assumption Robustness of Results Sensitivity analysis :  Perform stochastic simulations using different assumptions for certain key variables  Typical example would be to use different equity risk premium vs base assumption

CIA Annual Meeting Session 3304 Asset/Liability Modeling for Pension Plans – Practical Issues LOOKING BACK…focused on the future 35 Robustness of Results Deterministic scenarios :  Make projections based on fixed levels of key variables (e.g. equity returns, solvency interest rate, …)  Example – Company contribution in 2008 (millions $) Robustness of Results Deterministic scenarios :  Make projections based on fixed levels of key variables (e.g. equity returns, solvency interest rate, …)  Example – Company contribution in 2008 (millions $) Solvency interest rate Equity returns 0%8%16% -0.5% No variation %852