The Evolution of Asset/Liability Management (a summary)

The objective of most US institutions with assets to invest is to fund some sort of liability, as is the case with banks, insurance companies, pension funds, and so forth. As a result, asset/liability management (ALM) should be the investment focus and the basis for selecting the core portfolio. Insurance companies may be the birthplace of ALM and certainly have been the model of ALM discipline, thanks to the heavy regulations imposed on them. IAIS Standard No. 13 (International Association of Insurance Supervisors 2006) defines asset/liability management as the practice of managing a business so that decisions and actions taken with respect to assets and liabilities are coordinated. Therein lies the essence of proper ALM: It should be an orchestrated event based on enhancing the funded ratio (assets/liabilities). It should not have any other objective or interference, such as generic market indices, peer group comparisons, or inflation. In short, ALM can be defined as the process that deals with interest rate risk management. Banks and insurance companies have practiced ALM since their inception. Their ALM approach centers on the interest rate risk management of assets versus liabilities such that their risk/reward behavior is similar or matched. Financial theory offers no good reason for making a distinction between ALM as practiced by banks, insurance companies, or pensions. So, the time has come to stop treating pensions as anything different or special. In this sense, all liabilities are similar or have the same systematic risk—namely, interest rate risk. Therefore, ALM as practiced by banks and insurance companies should apply to pensions as well. The focus of this literature review is the evolution of ALM for pensions. One noticeable feature of pensions is that they have no regulations requiring asset/liability management or the matching of assets to liabilities. This lack of regulation may be the most important cause of the ballooning pension deficits of the past 13 years.