Financial institutions use the acronym ALM to describe what is now referred to as LDI (liability driven investing) by the pension industry. Why are there two acronyms, and how do they differ?
ALM stands for asset-liability management. Initially, it was often referred to as asset-liability matching, which, primarily, was thought to consist of interest rate risk management through cash flow management or duration matching. As time passed, practitioners realized that ALM could and should encompass a lot more than just duration matching:
- both assets and liabilities could be “managed” to reduce balance sheet risk;
- increasingly, product design incorporated other risks such as equity risk and longevity risk, which also needed to be managed; and
- even interest rate risk could include exposures to both real and nominal duration (i.e., inflation risk).
Fast-forward to today, when most financial institutions manage both sides of the balance sheet and accept balance sheet risk within certain risk tolerances. What are the parallels for pension plans? A few thoughts come to mind.
- Both assets and liabilities should be managed. It is unrealistic to expect a portfolio investment strategy to somehow eliminate all pension plan risk. Plan design features can also be considered: the use of target benefit plans, variable plan features, such as post-retirement indexation, that depend on the financial health of the plan (akin to participating insurance contracts) or, in the extreme, cost-sharing arrangements through variable employer and employee contributions.
- Investment strategy should indeed reflect the plan design but need not be “driven” by it. Risks can be managed but not eliminated, and the only perfect hedge is in the emperor’s garden in Japan. If one attempts an overly pure version of LDI, the only certain outcome will be increasing costs.
- A so-called matching portfolio is unlikely to behave well under all circumstances (rising or falling interest rates, inflation or deflation, or volatile equity markets). Investment strategies need to be flexible and manage the health of the plan’s funded status through multiple environments.
- Many risks are uncertain and not well defined. Inflation risk depends on one’s definition of inflation. Longevity risk reflects the characteristics of the member group and potential for anti-selection.
The approach taken to LDI or ALM also reflects the sophistication of the financial institution or plan sponsor. Increasingly, risk management includes the use of derivatives or other alternative asset classes, which require special expertise and can, in the worst case, give rise to more risk than they eliminate. Derivatives can be used to separate interest rate risk from credit risk, to eliminate downside risk on equity exposures or even to manage inflation risk or longevity risk. However, the use of derivatives requires more extensive documentation than ever before (not only ISDA agreements, but also credit support agreements, which are becoming routine), more complex financial reporting and valuation, and the potential need for collateral management. Similarly, most alternative investments require greater oversight and expertise, and may be beneficial only if one achieves top-tier performance.
LDI or ALM? These are both fancy acronyms to describe what financial institutions and plan sponsors should always be doing: managing their business in totality and understanding the big picture of their business risks and opportunities.