What is Asset-Liability Matching?

Asset-liability matching (ALM), also known as liability-driven investing (LDI), is a risk management strategy commonly used by institutional investors, such as pension funds, insurance companies, and endowments, to align the duration and cash flow characteristics of their assets with their liabilities. The primary goal of ALM is to ensure that the investment portfolio can meet future obligations, such as pension payments or insurance claims, in a timely manner while minimising the risk of funding shortfalls.

Here's how asset-liability matching works:

Identifying Liabilities: The first step in ALM is to identify and quantify the future liabilities or obligations that the institution is responsible for. For example, a pension fund needs to pay retirement benefits to its members, while an insurance company needs to cover policyholder claims.

Understanding Liabilities' Characteristics: It's essential to understand the nature, timing, and duration of the liabilities. This includes factors such as the timing and size of future cash flows, the duration of payment obligations, and the sensitivity of liabilities to changes in interest rates and other economic factors.

Constructing the Asset Portfolio: Based on the characteristics of the liabilities, the institution constructs an investment portfolio that is designed to generate cash flows and returns that match or closely align with the timing and magnitude of the liabilities. This typically involves investing in assets with cash flow profiles, durations, and risk characteristics that mirror those of the liabilities.

Minimising Funding Risks: By matching assets with liabilities, the institution aims to minimize funding risks, such as interest rate risk, inflation risk, and liquidity risk. ALM helps ensure that the institution has sufficient assets available at the right time to meet its obligations without having to rely on volatile market conditions or asset sales.

Monitoring and Adjusting: ALM is an ongoing process that requires regular monitoring and adjustment to reflect changes in market conditions, interest rates, and the institution's financial position. Asset-liability management models and techniques are used to assess the effectiveness of the strategy and make necessary adjustments to the asset portfolio.

The issue with real estate is that in difficult markets, usually when values have dropped, retail funds become inundated with withdrawal requests. Whilst these funds have cash reserves, and goof ALM strategies, real estate is illiquid and all withdrawal requests may not be able to be fully met without disposing of assets. More recently these funds have been seen to limit withdrawals or close the funds for withdrawals for a limited period to provide best value to their clients and avoid forced sales.

Overall though asset-liability matching is a prudent risk management approach that helps institutional investors better manage their financial obligations by aligning their investment assets with the timing and characteristics of their liabilities. This can enhance financial stability, reduce funding risks, and improve the likelihood of meeting long-term financial objectives.