What is Liability Driven Investing - FPA NY 2011

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Presentation slides delivered at the FPA NY Forum in April 2011.

Presentation slides delivered at the FPA NY Forum in April 2011.

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  • 1. What is Liability Driven Investing?
    Presented by:
    Brent Burns
  • 2. Liability-driven investing (LDI) is an investment strategy of a company or individual based on the cash flows needed to fund future liabilities
    Source: Wikipedia
  • 3. Decline in Traditional PensionsFortune 100 Companies 1985-2010
  • 4. Behavioral Finance Meets Asset Allocation
  • 5. 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.
  • 6. Client Needs
    Liquidity for current expenses
    Predictable near-term cash flows to cover near-term expenses (usually 8-10 years for those in retirement)
    Long-term growth to ensure sufficient growth to cover future needs
  • 7. Total Return Asset Allocation
    Long-Term Growth
    Cash Flow Needs
  • 8. 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.
  • 9. Total Portfolio
    Split into sub-portfolios to serve different purposes
    Liability Driven Investing
  • 10. Asset Allocation and Time HorizonUsing Asset Classes That Fit How Clients Think About Their Money
    8 Years – Prefers predictable bonds
    Today -
    Prefers liquidity of money market
    9 Years – Prefers higher return prospects of stocks
    Next Year – Prefers predictable bonds
    7 Years – Prefers predictable bonds
  • 11. How Often Bonds Beat Stocks
    S&P 500 and Intermediate Treasury Bond Index 1927-2009
  • 12. Worst and Average Spread
    S&P 500 and Intermediate Treasury Bond Index 1927-2009
  • 13. Using Individual Bonds to Build Income-Matching LDI Portfolios
  • 14. 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
  • 15. Income-Matching “Paycheck” Portfolios
    Immediate – Cash flows begin now
    Deferred – Cash flows begin when the client retires
  • 16. Building an Income-Matching Portfolio
    Engineered to match a specific cash flow stream
    $100,000 per year starting in 2 years
    3% inflation adjustment
    8 year time horizon
  • 17. 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.
  • 18. Timing Cash Flows
    Bond quotes 10/20/2010
  • 19. The Advantage of a Deferred Portfolio
    Cost = $763,530
    Duration = 6.2 Years
    IRR = 2.64%
  • 20. Immediate Portfolio Metrics
    Cost = $809,589
    Duration = 4.1 Years
    IRR = 2.46%
    Bond quotes 10/20/2010
  • 21. Leveraging the Yield Curve
  • 22. Optimization Process
  • 23. Mathematical Programming
  • 24. Tale of Two Allocations
    Total Return
  • 25. Double Duty From Bonds
    Standard Benefits
    Beta exposure to fixed income
    Dampen volatility
    Unique LDI Benefits
    Predictable cash flows
    Immunization from rising interest rates
    Years of Income
  • 26. “Flexible” rolling horizons
    Using time to ride out bad markets
    Taking more off the table when markets have been good
    Do Not Roll . . .
  • 27. Why Individual Bonds?
  • 28. Individual Bonds
    Bond Funds
  • 29. Legal Obligation
    Mutual Fund
  • 30. Decomposing Bond Fund Total Return
    Income Return
    Income return represents the sum of portfolio’s coupon payments
    Income is never negative
    Price Return
    Bond prices are inversely related to interest rates
    Bond prices fall as rates rise
  • 31. Impact of Interest Rates on Total Return
  • 32. 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
  • 33. Impact of Interest Rates on Total Return
  • 34. 30 years of falling interest rates has led to an unprecedented bull market for bonds.
  • 35. 30 Years of Tailwinds
    Total Return 11.3%
    Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
  • 36. 97%
    of taxable bond funds were started after 1981. Sustained rising interest rates will be new territory for most portfolio managers.
  • 37. “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
  • 38. Unprecedented bond fund flows will likely put added pressureon the bond market as rising rates cause losses and investors exit their bond funds.
  • 39. Bond Fund Flows
  • 40. 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.
  • 41. Impact of Interest Rates on Total Return
  • 42. 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.
  • 43. Historical Interest Rates Average Yield 1800-2010
    Long Depression
    Great Depression
    Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
  • 44. Japanese Interest Rates Since 1985
  • 45. 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
  • 46. Impact of Interest Rates on Total Return
  • 47. Rising Rates 1950-1981
  • 48. Rising Rates 1950-1981
  • 49. Rising Rates 1950-1981
  • 50. Volatility of Bond Funds Revealed
    5-year Treas.
    Source: BondDesk, 2009. Data: CRSP Survivor-Bias-Free US Mutual Fund Database; Classes: Intermediate Treasury and Short-Intermediate Treasury.
  • 51. Catch-22 for Bond Fund Investors
  • 52. 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.
  • 53. Japanese Interest Rates Since 1985
  • 54. 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 years
    Estimated loss ≈ -2%
  • 55. Headwind of Rising Rates
    Total Return 2.2%
    Average Coupon 5.6%
    Source: United States Treasury 10-year constant maturity yield 1962-2009, Global Financial Data 1800-1962. 5-year rolling average
  • 56. Rising Rates 1950-1981
  • 57. Managing the Shortfall
  • 58. 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.
  • 59.
  • 60. 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.
  • 61.
  • 62. 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.
  • 63.
  • 64. Other Income Strategies
    Dividend paying stocks
    Real Estate/REITs
  • 65. Annuities tend to be expensive and inflexible, but until now were one of the few investment products designed specifically to generate predictable income.
  • 66. 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.
  • 67. Income-Matching Portfolios Vs. Annuities
    Initial investment = $983,000
    total cash flows
    = $1,162,423
    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.
  • 68. Based on the Treasury yield curve and standard mortality tables, annuitants can expect to only receive
    of their premium in return.
    Annuities for an Ageing World, Olivia S. Mitchell and David McCarthy, June 9, 2002
  • 69. Challenges for Annuities
    Passing assets on to heirs
    Managing inflation
    Expenses, commissions, and fees
    Counterparty risk
  • 70. Other Income Strategies
    Dividend paying stocks
    Real Estate/REITs
  • 71. Dividend portfolios, the best of both worlds?
  • 72. 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
  • 73. 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
  • 74. Other Income Strategies
    Dividend paying stocks
    Real Estate/REITs
  • 75. 70%
    of REITs followed by Morningstar cut or suspended their dividends in 2009. Not a reliable paycheck either.
    Morningstar Industry Report 2010
  • 76. Key Points
    LDI ties portfolio construction to financial planning
    Bond funds face a real challenge in a rising rate environment
    Income-matching can bring more predictability and transparency to the retirement income problem
  • 77. 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).