LDI Asset Allocation, Risk and Capital Management.

Abstract

A Liability-Driven Investment (LDI) simulation by a white-box deterministic system, with long-term capital market assumptions of J.P.Morgan and Blackrock as key inputs, pays from asset cashflows the liabilities and the excess extractions that are each month the same fixed percentage of remaining liabilities to end with all assets sold and all liabilities and extractions paid. The author proposes this fixed percentage, FixPct, mapped on market probabilities, as the best overall performance and risk measure in an LDI-context. Extracting this way keeps solvency constant over time. FixPct is linear in funding defined as assets/liabilities. The asset part of a risk appetite and capital management policy can be expressed in terms of FixPct levels for certain market probabilities. FixPct facilitates insightful allocation optimization, performance and extraction monitoring and risk management in such a leveraged LDI-context. Riskier but higher yielding assets generally reduce risk and increase performance even in adverse markets. Rising interest rates are usually beneficial. Duration matching is not indicated. Simulations map LDI return and risk to assumptions on assets, allocation, market and models to enable insightful decisions.

Keywords: LDI, Liability Driven Investment, ALM, Assets & Liability Management, Investment Strategy, Asset Allocation, Investment Risk, Risk Appetite, Capital Management, Insurance Asset Management, Pension Fund Asset Management

JEL Classification: G11, G12, G18, G22, G23, G28, G31, G32