Ryan ALM has produced a position brief on various ALM strategies, including cash flow matching (CDI) and duration matching, but with a twist.
The purpose of duration matching is an attempt to match the interest rate risk sensitivity of assets to liabilities. The objective is to have the market value or present value (PV) changes (growth rate) in the bond portfolio match the market value or PV changes (growth rate) in liabilities for a given change in interest rates. But duration matching is only accurate for small parallel shifts in the yield curve. However, the yield curve rarely moves an equal number of basis points at every point along the curve. For more info, Ron Ryan wrote a research paper “The Seven Flaws of Duration” while he was the head of Ryan Labs.
Fortunately, bond management evolved to remedy these flaws by using Key Rate Durations, which attempt to match the duration of multiple points along the yield curve. Key Rate Duration is an improvement over using a single average duration, but it still has several deficiencies, including the fact that duration is a present value calculation requiring pricing each projected benefit with a discount rate yield curve (i.e., ASC 715 discount rates). As a result, 30 annual benefit payments require 30 separate discount rates.
Further evolution within fixed income has brought us to Dollar Duration Matching (DDM). DDM matches the Dollar Value change per basis point change in yield for assets with the Dollar Value change per basis point change in yield for liabilities. When the Dollar Duration of assets is matched to the Dollar Duration of liabilities for every year in the term structure of liabilities, then DDM is the most precise form of Key Rate duration matching because it matches the Key Rate durations at every point along the liabilities yield cure or benefits payment schedule (30 years = 30 key rate durations).
The Ryan ALM DDM approach greatly improves the accuracy of Key Rate duration matching by matching the Dollar Value changes in liabilities with the Dollar Value changes in assets across the term structure and yield curve for both assets and liabilities. The liabilities are represented by using a Custom Liability Index (CLI) to more precisely measure and monitor the dollar value movement in liabilities given any movement in interest rates.
Pension plans need to pay more attention to their plan’s specific liabilities. Using either CDI or DDM is a step in the right direction to securing the promised benefits, while reducing cost. Please don’t hesitate to reach out to Ryan ALM with any questions that you might have on either of these disciplines that we bring to asset/liability management.