Experts: Swaps - Innovative ideas for managing liabilities.

(From Professional Wealth Management (PWM))

Byline: Daniele Paglia

Defined benefit pension schemes and other institutional investors such as insurance companies are driven by two key objectives - to meet their liabilities in order to pay the pension benefits due to the plan beneficiaries, and to maintain or increase the surplus coming from active asset management decisions.

The traditional approach has been to concentrate entirely on asset maximisation. Only more recently, and driven by regulatory change, has the awareness for the need to specifically focus on liabilities arisen among schemes.

To match liabilities with assets is a difficult task in practice. The many simple approaches such as cash flow or duration matching offer differing risk/return trade-offs and, as such, they have their own set of advantages and disadvantages. Cash flow matching, for instance, provides low immunisation risk since cash flows of liabilities are exactly matched by cash flows generated from the portfolio's assets.

Startegy

However, as straightforward as this appears, the lack of availability of cash instruments and poor liquidity, particularly at the long end of the yield curve, makes it a difficult strategy to implement. This strategy also provides little room for security selection and consequently, whilst the portfolio can be immunised and liabilities matched, the delivery of attractive alpha returns is much more difficult to achieve. Other approaches, such as duration matching, have similar issues, with these strategies usually offering the potential for higher alpha generation but resulting in higher immunisation risk.