Are ALM scenarios and shock tables sufficient preparation for the future?

ALM emphasis quantitative results, but lacks any qualitative storylines. You need these storylines to flesh out scenarios and to help you understand what may happen. Paramount when it comes to preparing for an uncertain future.

By Manon ten Voorde, strategic risk advisor

Contemplating existential questions

In order to achieve long-term ambitions, pension funds have to distinguish between potentially fatal risks and acceptable risks. Scenario thinking should always be ingrained in a fund’s management DNA, as this method provides insight into existential questions. It can help funds evaluate their right to exist in a future characterised by tremendous change in the sector, for instance, or assist them in assessing how the organisation is structured. In addition, scenario thinking can be used to test the robustness of the balance sheet in euphoric and pessimistic financial markets.

Many pension funds use quantitative scenarios

Scenarios come in all shapes and sizes, and Dutch pension funds often employ various types of scenarios. Most of them, though, are quantitative, and many pension funds use ALM as a tool. ALM automatically generates scenarios based on yield and volatility assumptions, Another example is quantitative shock on a risk factor, such as interest, after which combinations of shocks can be presented in a shock table.

Narrative scenarios bring the future to life

True scenario thinking, however, involves using stories to detail what a possible future would look like. The emphasis is not on quantitative results, but on qualitative storylines. Storylines make scenarios more specific, and narrative scenarios with a long horizon – anywhere between 10 and thirty years – are called worldviews. Content wise, these scenarios are highly detailed images of what the future may look like in the long term, based on trends and uncertainties such as demographic developments, the climate problem and monetary policy. Challenging, yet plausible scenarios can be compiled by charting how these trends and uncertainties may develop. Consider, for instance, what the world would look like if technological development were to truly take off, or if people lived to be 130 years old.

Using a variety of tools increases robustness

In addition to long-term worldviews, there are also short-term risk management, or stress scenarios, which are an excellent way to test balance sheet risks over a period of three to five years. Again, these scenarios shouldn’t just emphasise quantitative results, but also consist of detailed storylines. Rising interest rates alone, for instance, aren’t as good as a scenario that also explains the underlying cause.

Whatever scenarios you use, it’s important that you don’t limit yourself to using one type, as using a variety of tools and analysis will increase your robustness.