Liability-relative Asset Allocation
Liability-relative asset allocation is an optimization approach that tries to address one of the limitations of mean-variance optimization. In particular, traditional mean-variance optimization does not take into account the fact that many investors build portfolios to use the cash to finance liabilities in the future. In other words, traditional MVO does not address the relationship between the asset investment portfolio and the liabilities that the investors will repay using the cash flow from the asset portfolio.
On this page, we discuss how liability-relative asset allocation works using an example from defined benefit (DB) pension plans. For more details on how to apply a liability-relative alloction see this this page.
Liability-relative asset allocation example
Let’s take the example of a defined benefit pension plan to illustrate how liability-relative asset allocation improves asset allocation. A pension plan has two components: a pension liability and an investment portfolio that is managed to meet the obligations (cash flow requirements of the liability). A pension plan promises workers a stream of payments upon retirement that is usually dependent on how long the employee has worked for the company, as well as the employee’s wage in the last few years before retirement. The pension liability represents the present value of the future retirement obligations of the plan.
The plan surplus and the fundings ratio can be calculated as follows
A pension plan is fully funded if the funding ratio is 1. If this ratio is less than 1, the plan is underfunded. If the ratio is higher than 1, the plan is overfunded.
The characteristics of the pension liability drive the returns and risk requirements of the investment portfolio and ultimately the asset allocation. A liability-based asset allocation recognizes that the value of the assets and the liabilities are driven by some of the same factors, so the correlations between changes in value of the two are important.
Liability-relative asset allocation is typically used by institutional investors such as pension funds, insurance companies, and banks. It is not very useful for individual investors, who will typically rely on other methods such as goals-based investing.