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LDI: An Enterprise-Wide Risk Management approach

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The pension systems are in a crisis. While an increasing dependency ratio (ratio of pensioners versus workers) has forced governments to decrease retirement benefits; corporate pension schemes have disappointed with their low returns and deficits. From an asset management perspective the investment strategy needs to protect a plan’s surplus in downward market conditions.

Mulvey et al. propose an integrated pension trust and corporate planning system. The pension plan can be closely linked to the economic path of the sponsoring company as well as the sponsoring company can be closely linked with the overall economy. Market conditions will affect the sponsoring company’s contribution policy. At each time period and possible future outcome (scenario) the value of the pension trust as well as its sponsoring company is calculated. The models objectives are: a) maximize shareholder value for the company, b) minimise the present value of contribution for the pension plan and c) provide an adequate level of safety for the pension plan.

In the current economic climate model based decision making is increasingly important for pension funds. The advantage is that they take into account complex real world constraints (such as tax and funding regulations). Models which support optimum risk decisions give the flexibility for many decision variables and objectives taking into account the interests of pension beneficiaries as well as that of the sponsoring companies.

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