Amongst the strategies to employ for the current interest rate environment is a Liability Driven Investment (LDI) approach.
LDI provides a framework for managing retirement income outcomes in what is likely to be a rising interest rate environment over the years ahead.
LDI places retirement planning goals at the centre of the investment approach leading to several key benefits:
- More stable level of income in retirement;
- More efficient use of capital – potentially need less retirement savings; and
- Better framework to make trade-off between allocation to equities and the retirement income portfolio in improving the likelihood of reaching desired standard of living in retirement.
Under LDI a more customised investment solution can be developed.
Conversely, if an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will likely need additional precautionary savings to meet their income requirements over retirement.
Therefore, while an LDI strategy increases the likelihood of reaching the retirement income objectives, it also achieves this with a more efficient allocation of investment capital.
The additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.
Accordingly, LDI potentially provides a better framework in which to evaluate the risk of meeting your retirement income goals in a rising interest rate environment.
Retirement Planning (mis) focus
Arguably the primary goal of retirement planning is to provide a stable and secure stream of income in retirement – income to support a desired standard of living in retirement.
However, retirement planning investment approaches often focus too heavily on accumulated wealth e.g. how much do I need to save to retire on?
This could potentially result in the wrong focus. For example, if a New Zealander retired in 2008 with a million dollars, their annual income would have been around $80k by investing in retail term deposits. Their income would have dramatically dropped in 2009 to approximately $35k. That is a big drop in income! But interest rates have fallen further, currently (Feb 2021) a million dollars invested in New Zealand Term deposits will generate around $10k.
As a result, the focus should not necessarily be on the size of the account value e.g. KiwiSaver account balance.
This reflects that volatility of capital and investment returns are not a true measure of a retiree’s investment risk.
Investment strategies that focus on capital preservation, such as holding high levels of cash and short-term fixed income strategies, are riskier and more volatile relative to the investment goal of generating a stable and secure stream of income in retirement.
Redefining the Retirement Goal
Those planning for retirement seek to secure essential (sufficient income) and aspirational goals (additional wealth accumulation) with a high probability of achieving them.
Accordingly, the goal for retirement can be split between retirement income (essential goals) and wealth accumulation (aspirational goals).
Those saving for retirement should be focusing on more than accumulated wealth alone. Other key considerations may include a desired level of retirement spending, meeting children’s education costs, healthcare costs, and a legacy. These can be considered as future liabilities that need to be met.
Consequently, a better measure of a retiree’s investment risk becomes uncertainty around how much spending can be sustained in retirement.
Liability Driven Investing
Liability-driven investment (LDI) strategies, otherwise known as asset-liability management (ALM), take a complete and holistic approach.
LDI explicitly includes an investor’s current and future liabilities e.g., essential and aspirational goals.
The traditional way of building portfolios focusses more on risk tolerance, return expectations, and accumulated wealth rather than achieving the investment goals outlined above.
LDI creates better portfolios, particularly when it comes to retirement needs. A more robust portfolio is generated, and the focus is on the key investment risk; failure to meet your investment objectives.
Obviously most financial planning processes take into consideration investment and retirement goals. Nevertheless, LDI makes retirement goals the central piece of constructing a portfolio. With LDI, portfolio allocations and management of risks are relative to meeting retirement objectives.
A more customised investment solution is developed.
See here for more on LDI.
The Benefits of LDI
Dimensional Funds Advisors (DFA) undertook analysis comparing two investment strategies relative to the goal of generating a stable and secure level of income in retirement:
- Goals based strategy that looks to generate sufficient income in retirement to match expected spending (consumption). This is the LDI strategy.
- Capital preservation strategy that is invested in Cash to manage the volatility of the account balance.
The following conclusions can be drawn from the DFA analysis:
- The LDI strategy provides a more stable stream of income in retirement;
- The LDI strategy provides greater clarity and confidence to plan for retirement; and
- The Cash strategy results in a high level of volatility relative to the goal of generating a stable level of income in retirement.
See here for a detailed review of the DFA Research.
In simple terms, the LDI strategy is a long-term bond portfolio that matches the expected retirement spending/consumption goal. Effectively, the LDI strategy generates cashflows to match future expected spending.
This reduces volatility relative to retirement spending goals.
Insurance Company’s implement a similar approach in meeting (paying out) future expected liabilities (insurance claims).
DFA conclude that “any strategy that attempts to reduce volatility using short- to intermediate-term fixed income, when the goal is a long-term liability like retirement consumption, will not be as effective as the LDI strategy.”
Although cash is perceived as low risk, it is not low risk when it comes to generating a steady and secure stream of income in retirement. Likewise, short term fixed income securities, while appropriate for capital preservation, are risky if the goal is to meet future spending/consumption in retirement.
In summary a LDI strategy provides the following benefits:
- More stable level of income in retirement;
- More efficient use of capital – potentially need less retirement savings; and
- Better framework to make trade-off between allocation to equities and retirement income portfolio in improving the likelihood of reaching desired standard of living in retirement.
If an investor runs with a Cash strategy, where the goal is primarily capital preservation, they will likely need additional precautionary savings to meet their retirement income requirements.
Therefore, while an LDI strategy increases the likelihood of reaching the retirement income objectives, it also achieves this with a more efficient allocation of capital.
This additional capital could be used for current consumption or invested in growth assets to potentially fund a higher standard of living in retirement, or used for other investment goals e.g. endowments and legacies.
Accordingly, LDI potentially provides a better framework in which to assess the risk of meeting your retirement income goals in a rising interest rate environment.
LDI Investment Framework for Individuals
Under the LDI model there are two portfolios: the liability portfolio and a return seeking portfolio. Most investment products offered today are return seeking portfolios with some dampening down of risk (measured by volatility of returns).
LDI is used by pension funds and insurance companies where their investment objectives and portfolios are primarily reflected in the terms of their future liabilities.
“Institutional” investment approaches such as LDI, Two-portfolio separation, and being more dynamic, are finding their way into wealth management solutions.
Goals-Based Investing is the wealth management counterpart to LDI. By way of example is EDHEC Risk Institute Goal-Based Investing Approach.
EDHEC suggest investors should maintain two portfolios:
- Goal-hedging portfolio – this replicates future replacement income goals; and
- Performance-seeking portfolio – this portfolio seeks returns and is efficiently diversified across the different risk premia – disaggregation of investment returns.
And, over time the manager dynamically allocates to the hedging portfolio and performance seeking portfolio to ensure there is a high probability of meeting retirement income levels.
Nevertheless, and most importantly, the Goal Based Investment framework outlined by EDHEC focuses on the goal of generating income in retirement.
Instead of worrying about fluctuations in capital, investors investing for retirement should worry about fluctuations of income in retirement.
With regards to capital specifically, the focus should be on avoiding permanent loss of capital, rather than fluctuations in capital.
See here for more on the EDHEC Goals Based Investment approach.
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