Magazine Issues » February 2009

EDHEC RESEARCH: The home guard

Pension funds use asset-liability management (ALM) to secure payments for retirees. Individual investors could make use of the same techniques, even for planning to buy a house, says Edhec’s David Schröder

The fundamental idea of asset-liability management (ALM) is to incorporate future financial liabilities directly in the portfolio optimisation process, thereby providing a better match between investment returns and payment obligations.

ALM is predominantly applied to entities such as pension funds or insurance companies, who have uncertain future payment obligations to their pensioners or buyers of insurance. Edhec has proposed to model a private client’s objectives – such as purchasing a house or maintaining a certain consumption level during retirement – as liabilities, and thus transpose the advantages of institutional ALM techniques to private wealth management.

Following the proposal Edhec carried out a feedback survey among wealth practitioners. This survey, which was carried out as part of Edhec’s ‘Private ALM’ research chair in partnership with Ortec Finance, found that there is overwhelming support for the idea of applying ALM techniques in a private wealth management context. However, while most of the practitioners are convinced of the potential advantages, some concerns regarding ALM’s successful implementation arise.  

A unique device
The key motivation for introducing ALM into the private wealth management sector is to tailor customised investment strategies that not only take the risk-return preferences of the clients into account, but also reflect the specific objectives and time horizons of their investments. Edhec’s study, Asset-Liability Management Decisions in Private Banking, showed that ALM enables the construction of more efficient portfolios compared to standard asset management solutions by explicitly including the personal liabilities into the asset allocation decision.

Overall, introducing ALM into private wealth management seems to be convincing to most practitioners: 87% of the respondents to our survey see the potential benefits of ALM for the private wealth management business.

The main advantage of ALM is considered to be its ability to manage clients’ long-term risks. Other crucial benefits of ALM are seen to be its clear focus on clients’ specific objectives and the positive impact ALM could have on the client relationship.

However, there are some concerns as well. Many practitioners perceive ALM techniques as highly complex. They thus not only fear low acceptance by wealthy individuals, but also see the challenge for their private wealth management teams of successfully implementing this new tool. Besides, respondents see some difficulties transferring the institutional ALM approach to private wealth management and want to see the models extended to include taxation.

Catering to the client’s specific needs is a central preoccupation of private wealth managers. Investment solutions are frequently adapted to the client’s risk aversion, tax situation, and investment horizon in order to take the specific objectives of the client into account.

The specific requirements of portfolio decisions in a private wealth management context have received particular attention from academic financial economists recently. Campbell (2006) argues that the development of optimal decision-making models for private households “is challenging because households face a number of constraints not captured by textbook models”. Campbell lists a long planning horizon, important holdings in non-tradable or illiquid assets, taxation, and borrowing constraints as key ingredients that put private investment decisions at odds with the assumptions in most academic asset allocation models.

Interestingly, there are tools in institutional asset management that have been specifically designed to integrate the actual constraints and objectives of long-term investors. Many pension funds and insurance companies adapt their portfolio management process in order to handle the presence of future financial objectives or constraints.

The bottom line is that the presence of specific financial objectives significantly changes the composition of the optimal portfolio, and taking into account such constraints through suitable ALM techniques allows for significant reductions in
shortfall risk.

But what do practitioners actually think about using ALM in private wealth management?

In principle, practitioners are extremely positive about the idea of introducing ALM techniques into the private wealth management sector. Ninety-five percent  of respondents agree that financial consulting should go beyond tax and legal advice, since it should also take clients’ financial constraints and private wealth objectives into account.

What is more, 75% of the respondents see the ability to deliver customised financial management as the predominant benefit private bankers can offer their clients – which is therefore their primary added value.

Eighty-seven percent of private bankers and asset managers who responded argue that ALM techniques, which would make it possible to focus on the client’s individual financial constraints, could become a considerable source of progress for their business. Some bankers even believe that ALM in private wealth management could become irreplaceable, as it might be one
of the few methods that allow private bankers to differentiate themselves from their competitors.

Difficult to understand
The main drawback is understanding – not just that clients might fail to understand the process – but 55% of respondents assume that the biggest challenge for implementing ALM is with the private wealth management teams themselves.

In fact, whether ALM is used or not, the client “is exposed to the competencies of the banker – this seems to be the biggest risk”, as one of the private bankers confessed.

As one respondent argued, there are already many tools and methods available. “The fundamental problem is that private banks and wealth managers do not always use them!” Adding ALM to the menu may not be the logical next step if other more basic tools or methods are not well understood by the private wealth manager.

Taxation is an issue. Taxes and unforeseen changes in taxation seem to be very important for private wealth management. It is even the most important part of some bankers’ business: “Tax efficiency is often overlooked. A good private banker might not be able to make money [for the client], especially in uncertain markets, but should be able to help the client keep from giving the taxman more than necessary.” The question then is how to make tax considerations part of an ALM framework.

Another problem is that some bankers see too many differences between wealth ALM and institutional, both with regards to investment style and objectives. “Private banking supposes a very tailor-made approach, which means that an industrial approach is difficult,” says one banker.  Or, as one banker puts it: “The liabilities of a wealthy individual are largely discretionary, in contrast to those of a pension fund.”

Indeed, modelling the liabilities of a private client may be more challenging than modelling those of a pension fund, for
which future liabilities are an aggregate of individual pensions.

Private bankers point out that the risks in private banking are mostly of a very individual nature, such as sudden changes in the employment or family situation, or – on a larger scale – unexpected changes to the client’s business risk.

Managing risks

An advantage is risk management. Most bankers (59%) argue that the main advantage of ALM is its ability to manage clients’ major multi-term risks. Our survey reveals that private bankers are quite critical of current practices in their profession: 56% of respondents believe that the main risk factors for private clients’ portfolios (inflation risk, interest rate risk, and asset price risk) are at present not well managed. Likewise, two-thirds of the respondents are outright dissatisfied with the risk tools and devices at hand.

Finally, ALM could also help private bankers strengthen ties with their clients. One respondent states: “I believe that developing a complete ALM approach is a key factor to ensure long-term relationships with the clients.” Or, as another banker says, ALM “enables us to better understand clients’ investment goals, which in turn helps us in our investment process”.
Some private banks have already chosen to use institutional money management practices in private banking: “We offer an institutional approach to private wealth management, which in our view is the way forward for the private banking industry,” says one respondent.

A positive response
From these points, it is clear that private wealth managers are drawn to the notion of using ALM in their industry. The vast majority is convinced that ALM is an interesting concept for the future of wealth management. There are some concerns, but overall it seems that private wealth managers strongly believe that the adoption of ALM techniques can provide additional value, while implementation is seen as a major challenge.

As proposals to use ALM in private wealth management are recent, the existence of these hurdles comes as no surprise. Additional research into the application of ALM to specific client contexts, as well as the education of private wealth management teams, would in all probability make it possible to clear these hurdles with greater ease.

(David Schröder, PhD, is a business analyst with the Edhec Risk and Asset Management Research Centre.)

©2009 Funds Europe