In last week’s blog, we discussed goals-based wealth management, a thoughtful approach to identifying and achieving your most important financial objectives.

Now let’s look at asset/liability matching, which is a key part of the goals-based investing framework.

Asset/liability matching originated in the pension world.  Pension managers are responsible for meeting specific objectives, namely, paying specific amounts of retirement benefits to a specific number of individuals at specific points in time.  To meet their ongoing “liabilities,” these managers must invest their assets carefully to earn the necessary returns, while taking the least risk possible.

As of 2013, liability-driven investing was practiced by more than half of U.S., U.K. and Canadian corporate pension plans, according to research from The Brandes Group.  Its use has more than doubled since 2007 ‒ an indication that the 2008 market crash forced many funds to adopt more prudent investment approaches.

Increasingly, asset/liability matching and liability-driven investing are making their way from pensions and other institutions into the world of individual and family investors.

The practices fit neatly into goals-based wealth management.  Rather than investing with the simplistic goal of “beating the market,” goals-based investors thoughtfully determine their financial objectives.  And then they translate those goals into “liabilities” ‒ future expenses such as college or retirement, each with a specific “price tag.”

Let’s use college funding as an example.  Rather than estimating that your daughter will need $120,000 for college, the asset/liability matching approach looks at how much she’ll need each year. In her first year, she might require $25,000, for instance.  The following year might cost $30,000, and so on.  With the projected price tags calculated, one can invest appropriately to help ensure the right amount of money is available when it’s needed.

Liability-driven investing can take more than one form.  For instance, very wealthy investors may use multiple investment portfolios, each dedicated to a specific objective.  For most investors, however, aggregating goals and corresponding investments into a single portfolio is equally effective and significantly less expensive.

Asset/liability matching is superior to the “beat-the-market” approach on a number of levels.  First, the approach forces us to plan for our goals, not merely hope for them.  This ensures that we will take the necessary steps to help ensure that the cash will be there when we need it.

Second, it helps investors to avoid unnecessary risk.  Liability-driven investors invest only aggressively enough to meet each goal:  The less risk taken to meet an objective, the better.

Some investors build unnecessarily risky portfolios with the mistaken belief that they need to invest very aggressively to meet their goals, while some savers don’t invest aggressively enough to earn the higher returns needed to meet their goals. Undertaking a study to measure and match your financial needs and investment assets will help you invest to better meet your objectives while taking on appropriate risk.

A pension asset/liability matching framework and goals-based investing are gaining in use among financial advisors working with individual investors.  Increasingly, investors understand that beating the market doesn’t mean much in and of itself. What matters most is having the money, when you need it, to fund the goals that are most important to you.  If you would like help implementing these techniques in your investment process, we may be able to help. That’s just part of what we do.