What is Liability Driven Investing - FPA NY 2011
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Transcript of What is Liability Driven Investing - FPA NY 2011
© Copyright Asset Dedication 2011
What is Liability Driven Investing?
Presented by:
Brent Burns
© Copyright Asset Dedication 2011
Liability-driven investing (LDI) is an investment strategy of a
company or individual based on the cash flows needed to fund
future liabilitiesSource: Wikipedia
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Decline in Traditional PensionsFortune 100 Companies 1985-2010
1985 1998 20100%
25%
50%
75%
100%
89%
67%
17%
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Behavioral Finance Meets
Asset Allocation
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Clients with multiple goals and varying timelines have trouble relating to stocks, bonds and cash are blended into a single portfolio. People tend to use mental accounts to manage various goals in their head. A pure Total Return approach creates a single portfolio that isn’t intuitively linked to the underlying goals.
Client Needs1. Liquidity for current expenses
2. Predictable near-term cash flows to cover near-term expenses (usually 8-10 years for those in retirement)
3. Long-term growth to ensure sufficient growth to cover future needs
Total Return Asset Allocation
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Splitting assets into multiple sub-portfolios helps clients better understand and stick to an allocation strategy. Bonds are specifically allocated to predictable current or future income (LDI). Equities are dedicated to long term growth, but are given time to ride through bad markets (long-term total return). Each asset class is dedicated to the function it best serves.
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Bonds
TotalReturn
Liability Driven Investing
Stocks
Total PortfolioSplit into sub-portfolios to serve different purposes
Today -Prefers
liquidity of money market
Next Year – Prefers
predictable bonds
7 Years – Prefers
predictable bonds
8 Years – Prefers
predictable bonds
9 Years – Prefers
higher return prospects of
stocks
Asset Allocation and Time Horizon
Using Asset Classes That Fit How Clients Think About Their Money
Time
StocksBondsCash
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How Often Bonds Beat Stocks
S&P 500 and Intermediate Treasury Bond Index 1927-2009
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Worst and Average Spread
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30-60.00%
-50.00%
-40.00%
-30.00%
-20.00%
-10.00%
0.00%
10.00%
S&P 500 and Intermediate Treasury Bond Index 1927-2009
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Using Individual Bonds to Build Income-Matching LDI
Portfolios
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Immunization Definition
“When a bond portfolio is immunized, the
investor receives a specific rate of return
over a given time period regardless of what
happens to interest rates during that time.”
Morningstar Bond Course 104
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Income-Matching “Paycheck” Portfolios
1. Immediate – Cash flows begin now
2. Deferred – Cash flows begin when the client retires
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Building an Income-Matching Portfolio
Engineered to match a specific cash flow stream
Example:
1. $100,000 per year starting in 2 years
2. 3% inflation adjustment
3. 8 year time horizon
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The following example show a target cash flow stream, which comes from the client’s financial plan, that is closely matched by the actual portfolio cash flows. Cash flows come from coupon payments generated by all the bonds and redemptions for each year.
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Deferred Income Portfolio
Year Issue Interest Principal
Portfolio Cash Flows
Target Cash Flows
2013 CD GE MONEY BK $23,591 $77,000 $100,591 $100,000
2014 CD AMEX BK $17,414 $88,000 $103,414 $103,000
2015 CD CAPITAL ONE BK $14,123 $94,000 $106,123 $106,090
2016 CD DISCOVER BK $9,472 $100,000 $109,472 $109,273
2017 FINANCING CORP $5,100 $107,000 $112,100 $112,551
2018 FINANCING CORP $5,100 $111,000 $116,100 $115,927
2019 FINANCING CORP $5,100 $114,000 $119,100 $119,405
2020 FED FARM CREDIT $5,100 $117,000 $122,100 $122,987
Total $889,000 $889,234
Timing Cash Flows
Bond quotes 10/20/2010
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The Advantage of a Deferred Portfolio
Cost = $763,530 Duration = 6.2 Years
IRR = 2.64%
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Immediate Portfolio Metrics
Bond quotes 10/20/2010
Cost = $809,589 Duration = 4.1 Years
IRR = 2.46%
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Leveraging the Yield Curve
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Optimization Process
To minimize the cost function where:
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Mathematical Programming
Minimize:
Subject to:
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Tale of Two Allocations
Total Return
LDI
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Standard Benefits• Beta exposure to fixed
income• Diversification• Dampen volatility
Unique LDI Benefits• Predictable cash flows• Immunization from rising
interest rates
Double Duty From Bonds
8
Years of Income
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“Flexible” rolling horizons
Years
Using time to ride out bad markets
Taking more off the table when markets have been good
Do Not Roll . . .
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Why Individual Bonds?
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Individual Bonds
Vs.
Bond Funds
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Legal Obligation
Vs.
Mutual Fund
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Decomposing Bond Fund Total Return
Price Return• Bond prices are inversely
related to interest rates
• Bond prices fall as rates rise
Income Return• Income return represents
the sum of portfolio’s coupon payments
• Income is never negative
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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In periods of falling interest rates, bond funds and individual bonds behave similarly. Both approaches invest for total return, which is greater than the stated YTM on the underlying bonds
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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30 years of falling interest rates has led to an unprecedented bull market for bonds.
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30 Years of Tailwinds
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
Total Return 11.3%
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of taxable bond funds were started after 1981. Sustained rising
interest rates will be new territory for most portfolio managers.
97%
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“People have unrealistic expectations of what a portfolio manager can do in a rising-rate environment.”
Jim Jessee, president of MFS Fund Distributors Inc. Investment News mutual fund round table in New York on Feb. 9, 2010
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Unprecedented bond fund flows will likely put added pressure on the bond market as rising rates cause losses and investors exit their bond funds.
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Bond Fund Flows
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Like periods of falling interest rates, bond funds and individual bonds behave similarly in periods of flat interest rates. Bond values stay at par, meaning that coupon interest is the primary source of returns.
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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There is plenty of historical precedent for sustained periods of flat interest rates following economic turmoil. Rates stayed low and flat for many years following the Long Depression in 1879 and again after the Great Depression. Japan has had more than a decade of low rates.
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Historical Interest Rates Average Yield 1800-2010
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
Lo
ng
De
pre
ssio
n
Gre
at
De
pre
ssio
n
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Japanese Interest Rates Since 1985
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The big advantage of individual bonds over bond funds becomes clear when rates rise. Because bond funds turnover the bonds in their portfolios, they have
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Impact of Interest Rates on Total Return
Bond Funds Individual Bonds
Falling Rates
Price Return
Income Return
Total Return > Income Return
Price Return
Income Return
Total Return > Income Return
Flat Rates
Price Return
Income Return
Total Return = Income Return
Price Return
Income Return
Total Return = Income Return
Rising Rates
Price Return
Income Return
Total Return < Income Return
Price Return
Income Return
Total Return = Income Return
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Rising Rates 1950-1981
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Rising Rates 1950-1981
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Rising Rates 1950-1981
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Volatility of Bond Funds Revealed
Source: BondDesk, 2009. Data: CRSP Survivor-Bias-Free US Mutual Fund Database; Classes: Intermediate Treasury and Short-Intermediate Treasury.
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
Taxable Bond Fund Scatter Plot
Standard Deviation
Ave
rag
e R
etu
rn
5-year Treas.
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Catch-22 for Bond Fund Investors
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Keep Duration Short and Rates Stay Flat (Japan)
The opportunity cost of staying short can be significant over time. You need to take on duration to pickup any yield in this kind of environment.
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Japanese Interest Rates Since 1985
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Extend Duration and Rates Rise
If rates rise and you are not immunized then losses are a function of duration and yield on the portfolio. Bond funds will suffer a price loss of roughly their duration for each 1% rise in yield, offset by the coupon interest.
Duration ≈ 5 yearsEstimated loss ≈ -2%
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Headwind of Rising Rates
Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
Total Return 2.2%
Average Coupon 5.6%
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Rising Rates 1950-1981
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Managing the Shortfall
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The following example shows the impact of changing interest rates on an $800,000 investment in both a bond funds and an income-matching portfolio designed to generate $100,000 per year plus 3% inflation over 8 years. Estimated bond fund shortfall, shown by the white line, are for a fund with a duration of 5 years and an SEC 30-day yield of 3%. When interest rates rise, the portfolio is exhausted early.
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An income-matching portfolio, shown as the red line, a has known worst case scenario of its yield to maturity and is always positive. Immunized from interest rate risk, the target cash flows are delivered regardless of loss in value of the bonds, because the return of principal and coupon payments are not affected by changes in price. If rates fall, gains can be harvested, however.
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Under the same withdrawal scenarios, an income matching portfolio will deliver target cash flows even when rising rates cause the underlying value of the bonds to fall. Bond funds, on the other hand, lose money, leading to a funding shortfall. The portfolio suffers the worst case of reverse dollar cost averaging and cannot sustain withdrawals from a declining asset base.
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Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
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Annuities tend to be expensive and inflexible, but until now were one of the few investment products designed specifically to generate predictable income.
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In the following example, equal amounts are invested in a 10-year income-matching portfolio and a 10-year period certain annuity. The income-matching portfolio generates more income.
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Income-Matching Portfolios Vs. Annuities
Initial investment = $983,000
Income-Matchingtotal cash flows = $1,162,423
Annuity total cash flows = $1,104,600
Income-Matching advantage = $57,823
Annuity quote from www.immediateannuities.com 4/21/2011; Price quotes for CDs and agency bonds used to build LDI portfolio 4/21/2011.
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Based on the Treasury yield curve and standard mortality tables,
annuitants can expect to only receive
81%-85% of their premium in return.
Annuities for an Ageing World, Olivia S. Mitchell and David McCarthy, June 9, 2002
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Challenges for Annuities
1. Passing assets on to heirs
2. Managing inflation
3. Flexibility
4. Expenses, commissions, and fees
5. Counterparty risk
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Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
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Dividend portfolios, the best of both worlds?
GrowthIncome
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Not when dividends are spent instead of reinvested. Jeremy Siegel showed that when investors spent the dividends growth on the remaining portfolio trailed the S&P 500 by 3.5% compounded from 1964 to 2005.1
Unique Risk and Return Characteristics of Dividend-Weighted Stock Indexes; Siegel, Jeremy, et al; 2006
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Investors who relied on dividends for income had to
take a big pay cut when payments from companies in
the S&P 500 dropped by…
January 2008 to January 2009
Standard and Poors S&P 500 Market Attributes Snapshot, January 2009
23.9%
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Other Income Strategies
• Annuities• Dividend paying stocks• Real Estate/REITs
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of REITs followed by Morningstar cut or suspended their
dividends in 2009. Not a reliable paycheck either.
Morningstar Industry Report 2010
70%
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Key Points
1. LDI ties portfolio construction to financial planning
2. Bond funds face a real challenge in a rising rate environment
3. Income-matching can bring more predictability and transparency to the retirement income problem
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Disclosures
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume
that future performance of any specific investment or investment strategy (including the investments and/or investment
strategies recommended or undertaken by Asset Dedication) made reference to directly or indirectly by Asset
Dedication in their literature or otherwise will be profitable or equal the corresponding indicated performance level(s).
Different types of investments involve varying degrees of risk, and there can be no assurance that any specific
investment will either be suitable or profitable for a client or prospective client’s investment portfolio. Historical
performance results for investment indices and/or categories generally do not reflect the deduction of transaction
and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of
which would have the effect of decreasing historical performance results.
Please remember that different types of investments involve varying degrees of risk, and there can be no assurance
that the future performance of any specific investment or investment strategy (including those undertaken or
recommended by Asset Dedication), will be profitable or equal any historical performance level(s).