CalPERS sharpens risk, liability tools

After watching the simultaneous declines of its market value and funded status during the financial crisis, the $204.8 billion CalPERS will conduct a full review of the methodologies underpinning its asset liability management (ALM) process.
The experience of seeing asset values drop below the levels calculated in its long-term projections makes CalPERS’ tri-annual ALM review particularly timely. Throughout 2010, the big fund will investigate the roles of asset classes in its strategic asset allocation, review its assumptions about capital markets and the inputs for portfolio optimisation, and hone ALM methodologies. 

Falls in market values and funding levels were common among US public pension funds during the financial crisis, and “raised a number of concerns including liability hedging, liquidity management and risk reduction strategies that require more focus and consideration in the asset allocation decision,”CalPERS states.

Initially, the ALM review will consider the macroeconomic risks that pension liabilities and asset classes are exposed to – such as liability, inflation, liquidity, interest rate risks – and redefine asset classes if required.

Using proprietary data, CalPERS will also review the fundamental characteristics of each asset class and perform risk, return and correlation analyses. It will then clarify the purpose of public equities, private equity, fixed income, real estate, inflation-linked assets and absolute return strategies in its overall portfolio, and determine suitable benchmarks for each asset class.

This month, the investment committee aims to finalise its recommendations on the roles of asset classes and assign fitting benchmarks to them.

Next, the fund will review the capital market assumptions for these asset classes, and test them under various economic scenarios. This will involve determining appropriate equity risk and illiquidity premiums for public equities and private assets.

An appropriate forecast period will be set for the ALM analysis, and risk, return and correlation assumptions will be developed as inputs into the process. These tasks are scheduled to be completed by May 2010.

In the final stage, alternative methods for determining asset mix scenarios will be assessed, including: current decision factor approach, and liability hedging policy portfolio with return-seeking implementation, the CalPERS investment committee notice states.

The fund will then develop more accurate liability factors for use in the ALM analysis, such as the return, risk and correlation of liabilities relative to assets. It will analyse actuarial assumptions with respect to forecast returns, and research problems with mean variance optimisation methods and present solutions.

To round off the ALM review, it will consider tail risk threats to the strategic and active asset allocations, and develop active risk budgets for asset class implementation. The review team will then recommend an ALM process and asset mix solution to be used by the investment committee in setting a strategic asset allocation. It aims to complete this in December 2010.