In the context of determining a strategic asset allocation, the asset/liability management (ALM) approach involves explicitly modeling liabilities and adopting the optimal asse allocation in relationship to funding liabilities. 6 For example, a DB pension plan may want to maximize the future risk-adjusted value of pension surplus (the value of pension assets minus the present value of pension liabilities). Investors other than those with significant future liabilities may adopt an ALM approach by treating future needs (such as for income) as if they were liabilities; we call those needs »quasi-liabilities.» Ziemba (2003) discusses this approach for individual investors; the method he describes involves setting penalties for failing to meet annual income needs and specifying a numerical value for the investor’s risk tolerance.

In contrast to ALM, an asset-only (AO) approach to strategic asset allocation does not explicitly involve modeling liabilities. In an AO approach, any impact of the investor’s liabilities on policy portfolio selection is indirect (e.g. through the level of the return requirement). Compared with ALM, an AO approach affords much less precision in controlling risk related to the funding of liabilities.

One example of an AO approach to strategic asset allocation is the Black—Litterman (1991, 1992) model. This model takes a global market-value-weighted asset allocation (the »market equilibrium portfolio») as the default strategic asset allocation for investors. The approach then incorporates a procedure for deviating from market capitalization weights in directions that reflect an investor’s views on asset classes’ expected returns as well as the strength of those views. For example, the weights in a globally diversified index provide a starting point for the investor’s policy portfolio weights irrespective of the investor’s liabilities (if any). In a later section, we illustrate a simple AO mean—variance approach to strategic asset allocation. However, mean—variance analysis has also been used in ALM approaches to strategic asset allocation, as we will illustrate later.

In a subsequent section we will discuss ALM approaches to asset allocation in more detail. ALM strategies run from those that seek to minimize risk with respect to net worth or surplus (assets minus liabilities) to those that deliberately bear surplus risk in exchange for higher expected surplus, analogous to the trade-off of absolute risk for absolute mean return in an AO approach. We may also describe ALM approaches as either static or dynamic.

To take the risk dimension first, the earliest-developed ALM approaches were at the risk-minimizing end of the spectrum. These strategies are cash-flow matching (also known as exact matching) and immunization (also known as duration matching). A cash-flow matching approach structures investments in bonds to match (offset) future liabilities or quasi-liabilities. When feasible, cash flow matching minimizes risk relative to funding liabilities. An immunization approach structures investments in bonds to match (offset) the weighted-average duration of liabilities. 1 Because duration is a first-order approximation of interest rate risk, immunization involves more risk than does cash-flow matching with respect to funding liabilities. To improve the risk-control characteristics of an immunization approach relative to shifts in the yield curve, portfolio managers often match the convexity as well as the duration of liabilities. Highly risk-averse approaches such as immunization remain important for investors such as banks and life insurers. ALM approaches permitting higher risk levels include those specifying the satisfaction of liabilities as constraints under which the best asset allocation will be chosen, as well as those incorporating an objective function that includes a penalty for failing to satisfy liabilities.

The second dimension concerns static versus dynamic approaches, and the contrast between them is important for understanding current practice in ALM investing. A dynamic approach recognizes that an investor’s asset allocation and actual asset returns and liabilities in a given period affect the optimal decision that will be available next period. The asset allocation is further linked to the optimal investment decisions available at all future time periods. In contrast, a static approach does not consider links between optimal decisions at different time periods, somewhat analogous to a driver who tries to make the best decision as she arrives at each new street without looking further ahead. This advantage of dynamic over static asset allocation applies both to AO and ALM perspectives. With the ready availability of computing power, institutional investors that adopt an ALM approach to strategic asset allocation frequently choose a dynamic rather than a static approach. A dynamic approach, however, is more complex and costly to model and implement. 11 Nonetheless, investors with significant future liabilities often find a dynamic approach to be worth the cost.

How do the recommended strategic asset allocations resulting from AO and ALM approaches differ? The ALM approach to strategic asset allocation characteristically results in a higher allocation to fixed-income instruments than an AO approach. Fixed-income instruments have prespecified interest and principal payments that typically represent legal obligations of the issuer. Because of the nature of their cash flows, fixed-income instruments are well suited to offsetting future obligations ( proportional reinsuranceypes ).

What types of investors gravitate to an ALM approach? In general, the ALM approach tends to be favored when:

• The investor has below-average risk tolerance.

• The penalties for not meeting the liabilities or quasi-liabilities are very high.

• The market value of liabilities or quasi-liabilities are interest rate sensitive.

• Risk taken in the investment portfolio limits the investor’s ability to profitably take risk in other activities.

• Legal and regulatory requirements and incentives favor holding fixed-income securities.

Tax incentives favor holding fixed-income securities.