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Liability Driven Investment

5b. Monitoring such a structure: Swap portfolio structure

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5.4          The choice of numeraire (e.g. whether the cash flows are in nominal or real terms, or if they are expressed using some present value metric) is not particularly important as long as the cash flow analysis ultimately precisely specifies the assumed cash flows. This explains which cash flows as per 5.3(d) are more problematic – they require lots more detail to specify precisely. It may be possible to develop suitable approximations that simplify them into a form that was more easily specifiable. It might also in practice be possible to simplify away liabilities of the form described in 5.3(c). It is also worth noting that the cash flows are not deterministic in nature. If the numbers of members involved is quite small then the random incidence of individual deaths will introduce uncertainty. For more sizeable schemes, the unpredictable nature of future changes in general levels of longevity is likely to be more significant (as is whether the mortality table in question is suitable for the actual type of individuals represented by the scheme membership).

 

5.5          Once the liabilities have been expressed in a suitably simplified form it becomes possible to structure swaps that capture the main characteristics of these cash flows. Liabilities that are fixed in nominal terms would be matched using swaps that generate fixed cash flows whilst those that are RPI-linked would utilise inflation swaps. LPI-linked liabilities can be catered for in a similar fashion although often their costs seem high to clients. This seems to be because clients worry less than the market as a whole does about the possibility of inflation becoming negative.

 

5.6          Performance (and risk) measurement and attribution of the swaps portfolio can then also be carried out by reference to the simplified cash flows, discounted (probably) at swap rates, versus mark to market movements in the value of the swaps.

 

5.7          There is a link between liability driven investment and fair valuation principles. The actuary will typically have placed some value on the liability cash flows. Assuming that the liability cash flow projections are truly correct (and ignoring some of the niceties surrounding credit risk on cash deposits etc.), we might ask how we can tell if this sum would actually be sufficient to provide all of the projected cash flows. This depends on whether the actuary’s valuation is bigger or smaller than the fair value of the liabilities derivable from the mark to market value of the swaps. It is not sufficient merely to compare the return on the liability driven portfolio with the movement in value placed on these liabilities by the actuary. The movement needs to be unbundled into its various parts, including potentially a part relating to the difference between the fair valuation and the actuary’s valuation.

 

5.8          Even the above analysis involves simplifications. For example, there is an implicit assumption in the above that the fund’s mortality experience can be well predicted at outset. But merely differentiating between nominal, real and LPI-linked increases provides no protection against unexpected improvements in mortality. There may be future discretionary benefit improvements. Active members’ liabilities are particularly difficult to project reliably in this context given their sensitivity to uncertain future member-specific salary increases. For a full picture one would in principle differentiate between each such risk, as per Section 4. In practice this is likely to be challenging, although at least thinking about such matters may help to highlight what sorts of risks a liability driven investment portfolio does or does not hedge against.

 


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