The stark shift in economic conditions over recent years, with runaway inflation and rising interest rates drastically altering the financial landscape, means the long-overlooked discipline of Asset Liability Management (ALM) has become the subject of renewed focus.
But it is important we chart ALM’s evolution over the past 25 years before we can then understand the challenges it faces today.
The evolution of ALM
Until the turn of the 21st Century, ALM had largely been the preserve of life insurance companies. They typically used vanilla, inflation-linked government bonds to hedge their longer dated liabilities, which were often inflation protected. Some pension funds attempted to hedge their liabilities using the same instruments as the life insurance firms, plus protecting their large equity exposure using equity index options. The systems, valuation methods and risk calculations did not have to be particularly sophisticated or integrated to cope with these assets.
Over the past two decades, ALM has undergone significant changes, becoming more integral to a broader range of financial services companies. New legislation in the UK – such as the Pensions Act 2004 and the Companies Act 2006 – required companies to put their pension funds’ assets and liabilities on their balance sheets. This led to a growth in Liability Driven Investment (LDI) programmes – an approach primarily used by pension funds to manage risks.
On the back of these LDI programmes, a market in interest rate and inflation swaps grew. As the LDI programmes became more mature, other bespoke Over-the-Counter (OTC) Derivatives became more common. This included Limited Price Index (LPI) Inflation Swaps, Inflation Options, Repos, Total Return Swaps, Swaptions and customised Equity Index Options.
Whereas once they had relied heavily on those inflation-linked government bonds, life insurers increasingly adopted many of these instruments to obtain better hedges for their liabilities. There are now over £2 trillion UK pension plans which have LDI hedging programmes. There is also a significant LDI market in the Netherlands and a smaller one in the United States.
However, as the ALM programmes and instruments being used by firms have diversified, the process of managing them became exponentially more difficult.
Managing ALM becomes more difficult
A bank, insurer or pension fund may have multiple ALM systems in place to manage different asset classes. The challenge is that those systems can often be fragmented, causing difficulties in combining all assets into a single portfolio for valuation and risk analysis against the liabilities – and this challenge has become far more acute in recent years.
During the early years of the millennium, following the burst of the dot com bubble, market conditions were relatively benign. While there was a blip during the onset of the global financial crisis, by early 2009, conditions had calmed once again – interest rates, inflation and equity market volatility fell to historically low levels and, despite limited and fragmented systems, ALM was easy to manage.
This period ended in 2022. The rapid rise in inflation after the Covid-19 pandemic prompted central banks to hike interest rates from near-zero to over 5%. This, in turn, brought increased volatility into the markets underpinning the assets used in hedging liabilities in ALM.
Suddenly, flaws in ALM systems and processes were magnified, and over the past two-and-a-half years, firms have been grappling with a plethora of ALM challenges:
- Fragmented Systems: different parts of an ALM scheme stored in different systems.
- Portfolio Analysis: difficulty in combining all the instruments of an ALM scheme into one portfolio to analyse as a whole.
- Valuation: difficulty in valuing all the OTC swaps with correct curves, managing custom-made equity linked derivatives and calculating asset and portfolio risk.
- Cash Driven Investing (CDI): difficulty in managing and estimating future cash flow requirements is challenging.
- Inappropriate PMS: the asset manager or insurance company’s core portfolio management system (PMS) is not suitable for managing ALM schemes, largely because the PMS cannot cope with OTC derivatives and asset liability benchmarks.
- Stress Testing: unable to easily stress test the ALM scheme to meet regulatory requirements.
- Benchmarks: difficulty in modeling the liabilities as a benchmark.
Solving ALM’s current challenges
The question, then, is how do companies solve these ALM pain points? Positively, while the discipline of ALM has indisputably become more complex throughout the 21st Century, and especially over the past three years, there are solutions to the challenges currently being faced.
Migrating fragmented systems into one, all-encompassing system is often an important first step. The likes of Aladdin and Bloomberg are examples of potential solutions that can provide a single view of ALM schemes and instruments.
Similarly, choosing the right PMS technology can make a significant different. If a company’s existing PMS is unable to support its requirements – being unable to cope with OTC derivatives, for instance – then they may consider implementing an agile ALM solution, such as TS Imagine or Bloomberg, alongside the legacy PMS.
In addition to implementing suitably robust tech solutions, firms could use the valuation and risk calculation of vanilla and custom-made OTC derivatives within existing or new systems; design stress tests to manage cash flow requirements and meet regulatory requirements; and turn liabilities, be it cash flows or future guaranteed returns, into benchmarks so they can be used for asset liability modelling and rebalancing.
Ultimately, there has been a sea change in the ALM space in recent years. Today, the growing complexities of LDI requires a multi-faceted approach to ensure effectiveness, achieve efficiencies and meet regulatory demands – and we should expect an ever-greater focus on the discipline of ALM, and the tools underpinning it, in the coming months and years.
About the Author
Raphael de Santos is a director within Consulting at Davies’ asset and wealth management team. Consulting at Davies was formerly known as Sionic – Davies Group acquired Sionic in 2021, rebranding it as Consulting at Davies in late 2023. Raphael has several decades’ experience in developing policies and leading teams in market data, index and portfolio construction, equity derivatives strategy, and research and trading.
