Level III Core · Principles of Asset Allocation

Asset-Only, Liability-Relative and Goals-Based Approaches to Asset Allocation

Updated 8 October 2026 · Fact-checked

These are three ways to set a strategic asset allocation. Asset-only focuses on asset risk and return, usually with mean-variance optimization. Liability-relative sets the portfolio against liabilities, as with a pension plan. Goals-based splits assets into sub-portfolios for separate goals, each with its own time horizon and required probability of success.

Understand Asset-Only, Liability-Relative and Goals-Based Approaches

A strategic asset allocation (SAA) is the long-term mix of asset classes you set for a client. The approach you pick depends on what the client must achieve. The exam tests whether you can match the approach to the investor and explain why.

Asset-only looks at the assets alone. You estimate expected returns, volatilities and correlations, then find the mix that gives the best return for a given risk. Mean-variance optimization (MVO) is the classic tool. Liabilities and goals enter only through the risk tolerance and constraints you set. It suits investors with no explicit liabilities, such as many endowments and foundations, and many wealthy individuals who think in terms of total portfolio risk and return.

Liability-relative starts from the liabilities. The aim is to fund them and manage the gap between asset value and liability value (the surplus). Risk is measured as the variability of surplus, not of assets alone. It suits defined benefit pension plans, insurers and banks. Assets that behave like the liabilities, such as long-duration bonds against long-dated fixed obligations, matter more than their stand-alone return. Pure liability matching is called liability-driven investing (LDI). Many plans also hold a return-seeking portfolio alongside the hedging portfolio.

Goals-based splits the client's wealth into separate sub-portfolios, one for each goal. Each goal has a time horizon, a required amount and a required probability of success. The goals-based framework is usually organised into three risk modules:

Personal risk: protects against downside to the client's personal situation. It funds essential needs, so it carries the highest required probability of success (such as 99%) and gets the safest assets.
Market risk: maintains the client's lifestyle. It carries a moderate required probability and a diversified mix of market assets.
Aspirational risk: wealth enhancement. These are goals the client would like to reach but can live without, so the required probability is lower and the assets can be riskier.

Goals-based suits individuals, and it fits how clients actually think about money.

The approaches are not exclusive. A goals-based plan can use MVO inside each sub-portfolio. A pension plan may use asset-only analysis for its return-seeking portfolio. A key point in goals-based investing is that the overall portfolio may not sit on the efficient frontier, and that can be acceptable because the client cares about meeting each goal, not about total-portfolio efficiency.

Key rules to remember

Surplus: Surplus = Value of assets − Present value of liabilities; The risk measure in a liability-relative approach is the variability of the surplus, not of assets alone.
Funded ratio: Funded ratio = Value of assets ÷ Present value of liabilities; Above 1 means overfunded. Below 1 means underfunded.
Asset-only portfolio variance (two assets): σp² = w1²σ1² + w2²σ2² + 2w1w2ρ12σ1σ2; Used inside mean-variance optimization. Asset-only risk is portfolio volatility.
Goals-based framework (not a calculation): Personal risk → Market risk → Aspirational risk; A framework, not a formula. Personal risk protects against downside to the client's personal situation and funds essential needs with the highest required probability. Market risk maintains lifestyle. Aspirational risk is wealth enhancement with the lowest required probability. Each module gets its own sub-portfolio, time horizon and required probability of success.

How to solve Asset-Only, Liability-Relative and Goals-Based Approaches questions

Use this method for any question asking you to choose, apply or critique an allocation approach.

1Read the client facts and identify who the investor is: individual, pension plan, insurer, endowment or other.
2Check for explicit liabilities with set amounts and dates. If they exist and drive the mandate, think liability-relative.
3Check for distinct goals with different horizons and importance. If the client talks about separate goals, think goals-based.
4If neither applies and the client is concerned with total return and risk, think asset-only.
5Name the risk measure that fits: asset volatility, surplus volatility, or probability of failing each goal.
6Link the choice to objectives and constraints: horizon, liquidity, risk tolerance, regulation.
7Answer the command word exactly: identify, state, justify or recommend. Give the approach and one clear reason tied to the case.

Quickest way: Three-question approach screen

When to use it: Use it when you have under two minutes on an item set question asking which approach suits an investor.

Ask: are there fixed liabilities to be paid? If yes, liability-relative.
Ask: are there several separate goals with different priorities? If yes, goals-based.
Ask: is the focus only on assets and total portfolio risk? If yes, asset-only.
If two fit, pick the one the vignette stresses most, then check the answer options for the matching risk measure.

Common mistakes in Asset-Only, Liability-Relative and Goals-Based Approaches

Saying asset-only ignores liabilities and goals completely.
The name suggests liabilities play no role.
Fix: Say they are not modelled explicitly. They still shape risk tolerance and constraints.
Measuring risk in a liability-relative approach as asset volatility.
Students carry over the MVO habit.
Fix: Use surplus risk: how asset and liability values move together.
Assuming the goals-based total portfolio must lie on the efficient frontier.
Efficient frontier thinking is strongly drilled.
Fix: Remember the sum of sub-portfolios may be inefficient overall. Success on each goal is the target.
Giving essential goals a low required probability of success.
Students link high risk with high importance.
Fix: Essential goals need the highest probability, so they get the safest assets. Aspirational goals tolerate lower probability.
Naming an approach without a reason from the case.
Students recall definitions but skip the application.
Fix: Add one phrase tying the approach to a client fact, such as fixed pension payments or separate goals.

Worked examples

Example 1

A defined benefit pension plan has assets of ₹500 crore and the present value of its liabilities is ₹625 crore. (a) Calculate the funded ratio and the surplus. (b) State which approach to asset allocation suits the plan and justify it in one sentence.

Show the solution

Funded ratio = assets ÷ PV of liabilities = 500 ÷ 625 = 0.80.
Surplus = 500 − 625 = −₹125 crore.
The plan has explicit, long-dated liabilities, so the allocation should be set relative to them.

Answer: (a) Funded ratio is 0.80 (80%) and surplus is −₹125 crore, so the plan is underfunded. (b) Liability-relative, because the plan's objective is to fund fixed pension obligations, so risk is measured as surplus variability.

Example 2

A client has three goals: covering essential living costs in retirement (needs a 99% probability of success), maintaining her current lifestyle (90%), and leaving a large gift to a charity (60%). Which approach fits, and how should the goals map to risk modules and asset choice?

Show the solution

Separate goals with different priorities and probabilities point to a goals-based approach.
Essential living costs at 99% belong in the personal risk module, which protects against downside to her personal situation. It needs the safest assets.
Lifestyle at 90% belongs in the market risk module. It can hold a diversified mix of market assets.
The charity gift at 60% belongs in the aspirational risk module (wealth enhancement). It can hold the highest-risk, highest-return assets.

Answer: Goals-based. Fund essential costs with low-risk assets (personal risk module), lifestyle with a diversified market portfolio (market risk module), and the gift with higher-risk growth assets (aspirational risk module), each in its own sub-portfolio.

Exam tips

Tie the approach to the investor type first. Pensions and insurers point to liability-relative, individuals with separate goals point to goals-based.
In essay sets, give the approach and one reason from the case. Extra theory earns no extra points.
A correct number alone earns full credit for a calculation, such as the funded ratio or surplus. Only the number of responses asked for is evaluated, in the order given, so give exactly that many answers in that order.
Watch for the risk module wording. Higher required probability means safer assets, not riskier ones.
Expect questions on the limits of MVO under asset-only. Know that inputs are uncertain and the results can be concentrated.

Asset-Only, Liability-Relative and Goals-Based Approaches: frequently asked questions

What is the main difference between asset-only and goals-based investing?

Asset-only builds one portfolio to maximise return for a given total risk. Goals-based splits wealth into sub-portfolios, each aimed at a specific goal with its own horizon and required probability of success.

When is the liability-relative approach used?

It is used when the investor has explicit liabilities that drive the mandate, such as a defined benefit pension plan or an insurer. Risk is measured by how the surplus varies, not by asset volatility alone.

Is mean-variance optimization always asset-only?

It is the standard asset-only tool, but it can be adapted. You can optimise on surplus for a liability-relative case, or use it inside each sub-portfolio in a goals-based plan.

Why can a goals-based portfolio be inefficient overall?

Each sub-portfolio is built to meet its own goal, not to sit on one overall efficient frontier. The client may accept lower total efficiency in return for a higher chance of meeting essential goals.