What is surplus optimization in asset-liability management?

Question

AcadiFi · Accepted Answer

Asset-liability management (ALM) recognizes that institutions like pension plans and insurers exist to fund specific liabilities, so the relevant risk is not asset volatility alone but the volatility of the surplus (assets minus liabilities). A plan can have stable assets but a wildly volatile surplus if liabilities move with interest rates while assets do not. Surplus return equals (asset return times asset value minus liability return times liability value) divided by surplus. Surplus volatility depends on asset volatility, liability volatility, and their correlation. Example: consulting actuary Makena Wanjiru-Petrovic at Rondebosch Pension Advisors analyzes Larchmont Steel Retirement Plan. Assets 850 million, liabilities 780 million, surplus 70 million. A 100 basis point rate drop lifts liability PV by 13 percent (duration 13) and the bond portfolio by only 6 percent (duration 6). Surplus falls by (850 times 6 percent minus 780 times 13 percent) equals negative 50.4 million — a 72 percent surplus drop. Solution: liability-driven investing (LDI). Extend asset duration to match liability duration, possibly via long Treasuries, STRIPS, or interest rate swaps, to immunize surplus against rate moves. Modern ALM optimizes in surplus space rather than asset space, often using a separate growth portfolio (equities, alternatives) and a hedging portfolio (long duration fixed income). ```mermaid flowchart LR A[Assets] --> S[Surplus] L[Liabilities] --> S S --> O[Optimize in
surplus space] O --> H[Hedging
portfolio] O --> G[Growth
portfolio] ``` For the CFA exam, contrast asset-only optimization (Markowitz) with ALM surplus optimization (Sharpe-Tint), and understand that the latter requires explicit liability modeling.

What is surplus optimization in asset-liability management?

Master Level III with our CFA Course

Related Questions

Practice Questions