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What is Liability Driven Investing? Presented by: Brent Burns
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
Decline in Traditional PensionsFortune 100 Companies 1985-2010
Behavioral Finance Meets Asset Allocation
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 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
Total Return Asset Allocation Long-Term Growth Cash Flow Needs Bonds Stocks Cash
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.
Total Portfolio Split into sub-portfolios to serve different purposes Bonds Stocks Total Return Liability Driven Investing
Asset Allocation and Time HorizonUsing Asset Classes That Fit How Clients Think About Their Money Stocks Bonds Cash 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  Time
How Often Bonds Beat Stocks S&P 500 and Intermediate Treasury Bond Index 1927-2009
Worst and Average Spread S&P 500 and Intermediate Treasury Bond Index 1927-2009
Using Individual Bonds to Build Income-Matching LDI Portfolios
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
Income-Matching “Paycheck” Portfolios Immediate – Cash flows begin now Deferred – Cash flows begin when the client retires
Building an Income-Matching Portfolio Engineered to match a specific cash flow stream Example: $100,000 per year starting in 2 years 3% inflation adjustment 8 year time horizon
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.
Timing Cash Flows Bond quotes 10/20/2010
The Advantage of a Deferred Portfolio Cost = $763,530  Duration = 6.2 Years IRR = 2.64%
Immediate Portfolio Metrics Cost = $809,589  Duration = 4.1 Years IRR = 2.46% Bond quotes 10/20/2010
Leveraging the Yield Curve
Optimization Process
Mathematical Programming
Tale of Two Allocations Total Return LDI
Double Duty From Bonds Standard Benefits Beta exposure to fixed income Diversification Dampen volatility Unique LDI Benefits Predictable cash flows Immunization from rising interest rates 8 Years of Income
“Flexible” rolling horizons Using time to ride out bad markets Taking more off the table when markets have been good Do Not Roll . . . Years
Why Individual Bonds?
Individual Bonds Vs. Bond Funds
Legal Obligation Vs. Mutual Fund
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
Impact of Interest Rates on Total Return
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
Impact of Interest Rates on Total Return
30 years of falling interest rates has led to an unprecedented bull market for bonds.
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
97% of taxable bond funds were started after 1981.  Sustained rising interest rates will be new territory for most portfolio managers.
“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
Unprecedented bond fund flows will likely put added pressureon the bond market as rising rates cause losses and investors exit their bond funds.
Bond Fund Flows
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.
Impact of Interest Rates on Total Return
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.
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
Japanese Interest Rates Since 1985
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
Impact of Interest Rates on Total Return
Rising Rates 1950-1981
Rising Rates 1950-1981
Rising Rates 1950-1981
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.
Catch-22 for Bond Fund Investors
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.
Japanese Interest Rates Since 1985
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%
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
Rising Rates 1950-1981
Managing the Shortfall
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.
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.
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.
Other Income Strategies Annuities Dividend paying stocks Real Estate/REITs
Annuities tend to be expensive and inflexible, but until now were one of the few investment products designed specifically to generate predictable income.
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.
Income-Matching Portfolios Vs. Annuities Initial investment = $983,000 Income-Matching total 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.
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
Challenges for Annuities Passing assets on to heirs Managing inflation Flexibility Expenses, commissions, and fees Counterparty risk
Other Income Strategies Annuities Dividend paying stocks Real Estate/REITs
Dividend portfolios, the best of both worlds?  Income Growth
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
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 23.9% Standard and Poors S&P 500 Market Attributes Snapshot, January 2009
Other Income Strategies Annuities Dividend paying stocks Real Estate/REITs
70% of REITs followed by Morningstar cut or suspended their dividends in 2009.  Not a reliable paycheck either. Morningstar Industry Report 2010
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
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).

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What is Liability Driven Investing - FPA NY 2011

  • 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 Bonds Stocks Cash
  • 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 Bonds Stocks Total Return Liability Driven Investing
  • 10. Asset Allocation and Time HorizonUsing Asset Classes That Fit How Clients Think About Their Money Stocks Bonds Cash 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 Time
  • 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 Example: $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
  • 24. Tale of Two Allocations Total Return LDI
  • 25. Double Duty From Bonds Standard Benefits Beta exposure to fixed income Diversification Dampen volatility Unique LDI Benefits Predictable cash flows Immunization from rising interest rates 8 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 . . . Years
  • 28. Individual Bonds Vs. Bond Funds
  • 29. Legal Obligation Vs. 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.
  • 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
  • 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
  • 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.
  • 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
  • 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 Annuities 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 Income-Matching total 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.
  • 68. 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
  • 69. Challenges for Annuities Passing assets on to heirs Managing inflation Flexibility Expenses, commissions, and fees Counterparty risk
  • 70. Other Income Strategies Annuities Dividend paying stocks Real Estate/REITs
  • 71. Dividend portfolios, the best of both worlds? Income Growth
  • 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 23.9% Standard and Poors S&P 500 Market Attributes Snapshot, January 2009
  • 74. Other Income Strategies Annuities 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).

Editor's Notes

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