'Retirement is the ugliest word in the language'

With recent depletions in asset values faced by retirement funds in Pakistan, one can't help but recall American novelist and short-story writer Ernest Hemmingway's words; "retirement is the ugliest word in the language". Yet, with a little bit of mathematics I can assure you that it doesn't have to be. Retirement funds have many options to structure adequate asset-portfolios to match their liability structures and maximise firm value.
In a stable environment where interest rates are constant this would be an easy task, because the outcomes would be more predictable. However, fluctuations in market values over the last few years have challenged retirement funds to develop adequate solutions to achieve their objectives.
In addition, government regulations, agency ratings, and informed customers have further challenged business strategies. An analysis of a retirement fund's assets and liabilities forms the basis of what is called Asset Liability Management (ALM). Using the central key figures that have been identified, it is then possible to put together an investment strategy which, with a high probability, guarantees the medium to long-term coverage of the retirement fund's obligations by the assets available.
This means that the financial situation of the employee benefits becomes more transparent to the Board of Trustees and, at the same time, provides a decision-making basis for the future investment strategy. The central premise behind managing investments using ALM for retirement funds is not just enhancing returns but rather meeting liabilities as a first priority and then making returns in excess of those liabilities.
As is common with other articles I write, a bit of gut wrenching mathematics is involved which should be left to the math savvy. But for those it appeals to, there's an entire universe of rainbows that opens up in terms of forecasting the future and using it to one's advantage.
In a nutshell, a mathematician can use probabilities of employees dying, retiring and resigning, the three events that can cause an outflow from the fund and combine them with forecasts of future salaries to determine what outflow can occur from the retirement fund in the future.
Once we have a fairly good assessment of these outflows, assets can be cherry picked to match these 'liabilities' in the future. The results of the study can then enable the Board of Trustees to come to a decision on the initial asset allocation, and allow them to look at the existing asset allocation critically and improve it if necessary.
Once this is achieved equity allocations can be matched with longer duration liabilities fearlessly as depletion of assets will be ridden out in the long term. An analysis shows that the maximum time taken to recover money lost in Pakistan's stock market is seven years with a low reached in two years so for any duration exceeding seven years equities will prove to be a great match.
Similarly, if the retirement fund in question has a large proportion of older employees due to retire in the immediate future, an appropriate proportion of the fund should be kept in a very liquid money market fund or say treasury bills for that duration.
However the relationship is not as simple as it seems. A young average age of a company does not always imply that a risky portfolio can be chosen. Younger employees have higher probabilities of withdrawing from a company by resignation which would mean that in the case of a provident fund that portion needs to be kept liquid whereas in the case of a pension fund depending on the rules of the company that portion would be taken as a gain and not paid out once the young employee were to resign.
The retirement funds industry also has the opportunity to consider statistics for financial instruments to facilitate the investment process. Such statistics recognise information regarding several different assets and liabilities in a single value. This recognition is a major step toward managing assets and liabilities more efficiently. The most important statistics used in analysing both assets and liabilities are duration and convexity, measures of price and interest rate risk.
When the maturity of the assets is greater than the maturity of liabilities, any change in interest rates will affect the value of assets more than it would the value of the liabilities. An ALM strategy would seek to match the duration of assets and liabilities and achieve an asset convexity higher than that of liabilities.
The latter would ensure that with changing interest rates, assets would rise more than liabilities and fall less with an adverse interest rate movement. Another interesting single number statistic is Value-at-Risk that sums up the market risk of a portfolio in one number. This number can be monitored on a daily basis to determine whether the risk being taken is too large or too small relative to the return.
According to Robert Heinlein, "anyone who cannot cope with mathematics is not fully human. At best he is tolerable subhuman who has learned to wear shoes, bathe, and not make messes in the house". The aim of this article is not to mock those who loathe mathematics but to recommend its use by outsourcing it to experts who can add value to the entire investment process. So bring a bit of mathematics to your retirement fund and start reaping the benefits of higher retention rates.
(Junaid Khalid, FRM is a Vice President at MCB Asset Management)