The defined-benefit (DB) pension plan is beginning to play abigger role in liquidity forecasting and planning at $67 billionPfizer. The financial crisis and slide in interest rates createdvolatility in the funded status of many DB plans. Pfizer's plan wasfully funded in 2006, but fell to 81% funded by 2011. While thecompany has made cash contributions to the plan to shore up theassets and while asset valuations have rebounded, these pluses havelargely been offset by a sharp rise in pension liabilitiesresulting from lower discount rates.

Pfizer recently decided to move from a DB plan to an enhancedsavings plan, which will be completed by 2018. Until then, itneeded a sophisticated, reliable model to support planning forpension liquidity and its earnings-per-share impact. The pensionworld is full of predictive models, but Pfizer wanted somethingmore integrated and customized, so it built its own bettermousetrap at a cost of over 500 man-hours.

Pfizer developed the pension liquidity model over several yearsand implemented it in the second quarter. The model does notproduce a single forecast, but instead simulates thousands ofequally likely future scenarios with confidence ranges around thescenarios, explains Amit Singh, senior director of capitalmarkets. One big challenge is forecasting interest rates.“Due to their mean-reverting and stochastic nature, interest ratesare difficult to simulate,” Singh notes. Pfizer chose theHull-White method to calibrate to current market expectations forinterest rates because it is forward-looking instead of historical,unlike most interest-rate models, he says.

Predictions on asset classes and interest rates had to beintegrated and internally consistent. Simulating future values forasset classes and correlating them is common practice, Singhacknowledges, but leaving interest rates out of the correlation mixcan result in “nonsensical future scenarios where, for example,interest rates decrease in a simulated year but fixed assetsperform badly at the same time, something that would never reallyhappen,” he says. “We decided that rather than parse through allthe simulated paths and weed out the unreasonable ones beforeusing the rest, which would make the model tedious and sloppy, wewould create a technique that did not generate any unrealisticpaths by making interest rates a part of the asset correlationsmatrix. This was a breakthrough that made our model efficient.”

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