Liability matching is when the value of an investor’s assets moves in line with the value of their liabilities. In other words, what they own behaves like what they owe.
In this post we’ll explore why this matters and how institutions do it.
Why matching liabilities matters
Liability matching matters because, if the value of the institution’s liabilities increases without a corresponding increase in the value of its assets, then the financial position of the institution will have worsened.
In the case of a DB pension fund, this could trigger the need for the sponsor to pay additional money into the fund. Even if additional payments are not immediately triggered, the share price of the sponsor may suffer if investors think that providing ongoing support to the pension fund is going to prevent the company doing other things, like investing to grow the business or paying dividends.
What do me mean by a “liability value”?
In an earlier post, we introduced the concept of present value.
To pay for a future promise, an investor doesn’t need to have the full amount set aside now. This is because they can assume that they will earn some investment returns before the promise needs to be paid. The higher the investment returns they expect to earn, the less they need to put aside – i.e. the lower the present value.
Here’s a simple example. Suppose that an institution knows it needs to make a payment of £1 million, in 1 year’s time. It doesn’t need to have the full £1 million today, as it knows it will earn a return over the next year to help pay for it.
Suppose the institution is confident it can earn 3% interest over the next year. Then it needs to have about £970,0001 to be sure of being able to make the £1 million payment in a year’s time. £970,000 is the present value of the £1 million payment.
Why liability values change over time
The investment return we can expect to earn on our assets is not fixed in time. Remember from this post that asset returns are made up of building blocks, and the most basic building block, which appears in the returns of all assets, is the risk-free rate.
Investors’ forecasts for the risk-free rate will change all the time. In particular, their forecasts will move in line with the interest rates available on low-risk assets like government bonds. As forecasts for the risk-free rate change over time, so do forecasts for investment returns and so do the present values of institutions’ liabilities.
Returning to our example, suppose that something happens in financial markets that causes the forecasted risk-free rate for the next year to fall, so that now the institution only expects to earn 2.9% interest for the rest of the year, rather than the 3% before.
If the institution decides to re-run the numbers the next day, it will discover it now needs to find about £1,000 more to be sure of meeting its £1 million obligation2.
Value matching simply means investing in assets that change in value in the same way as the institution’s liabilities. When the present value of the institution’s liabilities increases, the value of its assets increases. When the present value of its liabilities falls, the value of its assets falls.
Liability matching: the change in the asset value is the same and the change in the liability value.
How DB pension funds match their liabilities
An obvious way to value match is to simply invest in assets that look very much like the liabilities.
Recall from last week’s post that a pension fund’s liabilities are a stream of regular cash flows. A portfolio of bonds will also provide a predicable stream of cash flows: coupons and maturity proceeds, if those bonds are held until they mature and the bond issuer doesn’t default.
So, it makes sense that bonds with low default risk like government bonds are a good value match to liabilities. For this reason, cash flow matching and value matching often go hand in hand; a very closely cash flow matched pension fund will also be very closely value matched.
The challenge with this approach is that government bonds don’t offer a very high rate of return. So fully value matching liabilities using only real-world assets is expensive. For this reason, pension funds have turned to a strategy known as Liability Driven Investing.
We’ll look at Liability Driven Investing in more detail in the next post.
Liability risk for individual savers
When we retire we need to fund our living expenses until we die. This stream of payments is similar in many ways to a DB pension scheme’s liabilities.
Like a pensions fund’s liabilities, the money we’ll need have saved to fund our retirement varies over time. This creates risk and uncertainty as we approach retirement.
We’ll look at this more, and how we can adapt some of the approaches used by DB pension funds to manage this risk, in a future post.
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