Stochastic Asset Modelling

[bumblebee]

In a past exam question about valuing the assets in a defined contribution pension scheme it asks for a description of possible methods of valuation.

The answer stated Market Value and Discounted Cashflow methods but did not go on to say about possible Stochastic valuation.

I would have thought that this was the MOST appropriate given the nature of investment returns - why is this not a suitable method, AND would it be if it were a DB scheme where contributions need to be set, and "option" of transferring out has more impact on the scheme (i.e. reserving / solvency requirements)

I keep finding that my answers veer off the wrong way and I'm writing a lot of irrelevant points even though when I'm writing the answer I feel like I've really understood the question!

 

[Mark Willder]

In a past exam question about valuing the assets in a defined contribution pension scheme it asks for a description of possible methods of valuation.

This was September 2008 Paper 2 Question 1 part i). Part ii) refers to a defined contribution (DC) scheme, but part i) is talking about both DC and DB (defined benefit).

The answer stated Market Value and Discounted Cashflow methods but did not go on to say about possible Stochastic valuation.

I would have thought that this was the MOST appropriate given the nature of investment returns - why is this not a suitable method, AND would it be if it were a DB scheme where contributions need to be set, and "option" of transferring out has more impact on the scheme (i.e. reserving / solvency requirements)

Market value is often considered to be the most appropriate way to value assets as it represents the fair value at which the assets could be realised if they were sold today. If the market value is unavailable (eg unquoted shares, property etc) we might need to use an alternative method.

In the past discounted cashflow methods were most often used in DB pension calculations, but in recent times market valuations are normally used.

For a DC scheme market values would always be used if they are available as the benefit is determined by the value of the assets at retirement.

A stochastic valuation of the assets would not be appropriate if a market value were available. A DB scheme might have benefits containing options, so you could decide to value the liabilities stochastically (although this would be rare in practice), but this does not change the underlying value of the assets.

Problems with a stochastic valuation of assets include: subjectivity, complexity, difficult to explain, does not equal market value (which matters when you are buying and selling assets regularly as these trades take place using market value).

A stochastic valuation of assets cold be useful for unquoted derivatives as a market value will not be available.

I hope this helps. Good luck with the exam.

Mark

 

[bdcd1]

DB pension scheme contribution calculation

What is the (simplified) formula for calculating the contribution required in a DB scheme? The reason I ask this question is so that I can think of the formula and may be generate ideas to answer questions of 'contribution rates'. For example: CA1 Sept 2007, Paper2 Q5.
From CT5, I remember that the benefits would be something like:
(n/60)*(avg salary in last 3 years).
To answer the question from Sept2007, one way to reduce volatility of future contributions would be to reduce the future salary growth rates. This point is covered in the Examiners Report. Increasing the 60 to 80 is not possible in this particular case as the question says that the method should not change
Most of the points in the Examiner Report are 'common sense' points - but was hoping that some points could be generated straight by looking at the formula and seeing what can be changed.

Cheers

 

[Mark Willder]

What is the (simplified) formula for calculating the contribution required in a DB scheme? The reason I ask this question is so that I can think of the formula and may be generate ideas to answer questions of 'contribution rates'. For example: CA1 Sept 2007, Paper2 Q5.
From CT5, I remember that the benefits would be something like:
(n/60)*(avg salary in last 3 years).
To answer the question from Sept2007, one way to reduce volatility of future contributions would be to reduce the future salary growth rates. This point is covered in the Examiners Report. Increasing the 60 to 80 is not possible in this particular case as the question says that the method should not change
Most of the points in the Examiner Report are 'common sense' points - but was hoping that some points could be generated straight by looking at the formula and seeing what can be changed.

For my response to this question, please see the thread "Calculating contributions for DB schemes".

Best wishes

Mark