The li­a­bil­ity bench­mark

Finweek English Edition - - Property Compass - Jo­hann Swanepoel San­lam In­vest­ment Man­age­ment

LET’S ASK A CRIT­I­CAL ques­tion: what re­ally drives the long-term per­for­mance out­comes of re­tire­ment funds? What the aca­demics will tell you is that, by and large, it is the strate­gic as­set al­lo­ca­tion de­ci­sion and its com­men­su­rate bench­mark that can ac­count for as much as 90% of vari­abil­ity in per­for­mance. (Note that the an­swer is not man­ager’s stock se­lec­tion, sec­tor ro­ta­tion or mar­ket tim­ing.) But, aca­demic de­bate aside, if the strate­gic bench­mark does have such an over­whelm­ing in­flu­ence on out­comes, shouldn’t it be the most im­por­tant dis­cus­sion?

The goal

Let’s take as given that the an­swer is af­fir­ma­tive.

The en­tire re­tire­ment fund in­dus­try ex­ists to fa­cil­i­tate the process whereby in­di­vid­u­als (or groups of in­di­vid­u­als) save reg­u­lar con­tri­bu­tions through­out their work­ing lives to se­cure an in­come from their sav­ings af­ter re­tire­ment. There are two sides to this li­a­bil­ity. From the fund’s per­spec­tive, its obli­ga­tion (li­a­bil­ity) would be de­fined as pro­vid­ing the ben­e­fit promised to the mem­ber. From the mem­bers’ per­spec­tive, the li­a­bil­ity is their spending re­quire­ment af­ter re­tire­ment ‒ ie, food, shel­ter, med­i­cal costs, trans­port, leisure, etc.

Loosely trans­lated this sets the obli­ga­tion as a set of fu­ture ex­pected cash flows to the mem­ber. By defin­ing the prob­lems in th­ese terms, it should be pos­si­ble to place a mar­ket value on those cash flows by dis­count­ing them us­ing a suit­able yield curve. That way of valu­ing cash flows is used ev­ery day in the pric­ing of bonds and life an­nu­ities, as well as in the val­u­a­tion of de­fined ben­e­fit (DB) re­tire­ment li­a­bil­i­ties world­wide.

One then ad­dresses the in­vest­ment man­age­ment of this obli­ga­tion by sim­ply build­ing a match­ing port­fo­lio that meets the monthly cash flow reguire­ments.

The li­a­bil­ity bench­mark

The li­a­bil­ity bench­mark is very much re­lated to this con­cept of a match­ing port­fo­lio. In fact, if per­fect cash flow match­ing is pos­si­ble the li­a­bil­ity bench­mark is noth­ing more than the in­dex of the per­for­mance of the match­ing port­fo­lio over time. How­ever, in prac­tice per­fect match­ing isn’t al­ways pos­si­ble, mainly due to a lack of very long dated in­stru­ments and you can ex­pect a match­ing port­fo­lio to de­vi­ate slightly from the li­a­bil­ity bench­mark.

Ex­am­ple

The best way to ex­plain this con­cept is to look at a worked ex­am­ple. ABC Pen­sion Fund is a closed DB fund with 1 000 pen­sion­ers. The rules of the fund guar­an­tee an an­nual pen­sion in­crease in line with con­sumer price inflation. By ap­ply­ing an ap­pro­pri­ate mor­tal­ity ta­ble to the ac­tual fund mem­ber­ship you can de­rive a set of ex­pected fu­ture cash flows for the fund. A cur­rent value can then be cal­cu­lated by valu­ing the cash flows us­ing an ap­pro­pri­ate real yield curve. (That’s the same as con­struct­ing a match­ing port­fo­lio of as­sets and then tak­ing the mar­ket value of that port­fo­lio. There may be a slight dif­fer­ence when the li­a­bil­i­ties ex­tend fur­ther than the avail­able as­sets, in which case per­fect match­ing isn’t pos­si­ble.)

The li­a­bil­ity bench­mark is then con­structed over time by valu­ing the ex­pected cash flows on a reg­u­lar ba­sis ‒ say, ev­ery month us­ing the lat­est yield curve.

The use

The main use of the li­a­bil­ity bench­mark is, of course, to keep track of the change in the value of the li­a­bil­i­ties over time, and by com­par­ing it with the change in the value of the as­sets you can eas­ily keep track of the fund­ing level (the abil­ity of the fund to meet fu­ture li­a­bil­ity cash flows).

As the li­a­bil­ity in­dex also rep­re­sents the li­a­bil­ity-match­ing port­fo­lio it can be used to de­ter­mine the to­tal risk of the fund’s in­vest­ment strat­egy in re­la­tion to its li­a­bil­i­ties. That’s much more in­for­ma­tive than the usual mea­sure of ac­tive risk com­pared to a bench­mark that has no re­la­tion to the li­a­bil­i­ties. Here we have three dif­fer­ent in­vest­ment strate­gies rel­a­tive to the li­a­bil­ity bench­mark. (Bal­anced, CPI+5% and cash). See­graph­s1and2).

Ab­so­lute volatil­ity (in as­set-only space)

In ab­so­lute terms the li­a­bil­ity bench­mark can be quite volatile, as it’s ba­si­cally a type of long du­ra­tion inflation-linked bond port­fo­lio in this ex­am­ple. In ab­so­lute terms, cash is the “least risk” port­fo­lio. (See graph 3)

Even though the bal­anced port­fo­lio out­per­formed the li­a­bil­i­ties for most of the pe­riod it’s clear there’s con­sid­er­able risk in that strat­egy rel­a­tive to its li­a­bil­i­ties. (See graph 4) Rel­a­tive volatil­ity (in as­set-li­a­bil­ity space) If we now con­sider the per­for­mance

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