The sustainability of Malaysia’s pension system: implementation of deterministic linear programming

Abstract

Managing pension funds requires fund managers to meet the objectives of the fund while ensuring that the fund is always adequate to meet its liabilities as well as satisfying regulatory requirements. Market uncertainty and regulatory constraints require the fund to use alternative investment strategy to construct its asset allocation efficiently. In this paper, we employ a deterministic linear programming model to analyse Malaysia’s Employees Provident Fund (EPF). This study is conducted based on two frameworks. On one hand, we develop expected future cash flows and on the other hand, we analyse the model that solve asset allocation problem for the EPF. The model, generates two random factors namely a future asset model and future liabilities model. We employed Vector Autoregressive model to generate future returns of five asset classes i.e. equity, money market instrument, Malaysia government bond with 1 and 10 years of maturity date and property. Future liabilities factors were derived from two sub-models; population and salary. In population model, the future status of the EPF members was determined using a Markov Chain model. Then, the random factors of assets and liabilities were used in the asset liability model (ALM) based on linear programming (LP) and fixed mix (FM) strategy. The results of the research are grouped in two levels. First, we briefly discuss the finding of the random factor model and then we analyse the optimal investment strategy for the EPF. In terms of finding an optimal investment strategy, the FM strategy generated higher expected terminal wealth than the LP strategy. This finding suggests that FM is superior to the LP optimization investment strategy. In addition, we find that the higher dividend distributed to the members may result in decreasing of the expected terminal wealth of the fund for both strategies. This portrays that dividend distribution policy may affect the financial soundness of the EPF in the long run.