what is liability driven investing - fpa ny 2011

© Copyright Asset Dedication 2011

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 liabilitiesSource: Wikipedia


Decline in Traditional PensionsFortune 100 Companies 1985-2010

1985 1998 20100%

25%

50%

75%

100%

89%

67%

17%


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 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


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.


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


How Often Bonds Beat Stocks

S&P 500 and Intermediate Treasury Bond Index 1927-2009


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


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

1. Immediate – Cash flows begin now

2. Deferred – Cash flows begin when the client retires


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


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.


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


The Advantage of a Deferred Portfolio

Cost = $763,530 Duration = 6.2 Years

IRR = 2.64%


Immediate Portfolio Metrics

Bond quotes 10/20/2010

Cost = $809,589 Duration = 4.1 Years

IRR = 2.46%


Leveraging the Yield Curve


Optimization Process

To minimize the cost function where:


Mathematical Programming

Minimize:

Subject to:


Tale of Two Allocations

Total Return

LDI


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


“Flexible” rolling horizons

Years

Using time to ride out bad markets

Taking more off the table when markets have been good

Do Not Roll . . .


Why Individual Bonds?


Individual Bonds

Vs.

Bond Funds


Legal Obligation

Vs.

Mutual Fund


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


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


Flat Rates

Price Return

Income Return

Total Return = Income Return

Price Return

Income Return


Rising Rates

Price Return

Income Return

Total Return < Income Return

Price Return

Income 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




Falling Rates

Price Return

Income Return


Price Return

Income Return


Flat Rates

Price Return

Income Return


Price Return

Income Return


Rising Rates

Price Return

Income Return


Price Return

Income Return



30 years of falling interest rates has led to an unprecedented bull market for bonds.


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%


of taxable bond funds were started after 1981. Sustained rising

interest rates will be new territory for most portfolio managers.

97%


“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 pressure on 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.




Falling Rates

Price Return

Income Return


Price Return

Income Return


Flat Rates

Price Return

Income Return


Price Return

Income Return


Rising Rates

Price Return

Income Return


Price Return

Income 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


Lo

ng

De

pre

ssio

n

Gre

at

De

pre

ssio

n


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




Falling Rates

Price Return

Income Return


Price Return

Income Return


Flat Rates

Price Return

Income Return


Price Return

Income Return


Rising Rates

Price Return

Income Return


Price Return

Income Return



Rising Rates 1950-1981


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.


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 yearsEstimated loss ≈ -2%


Headwind of Rising Rates


Total Return 2.2%

Average Coupon 5.6%


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-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.


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

1. Passing assets on to heirs

2. Managing inflation

3. Flexibility

4. Expenses, commissions, and fees

5. Counterparty risk


Dividend portfolios, the best of both worlds?

GrowthIncome


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

Standard and Poors S&P 500 Market Attributes Snapshot, January 2009

23.9%


of REITs followed by Morningstar cut or suspended their

dividends in 2009. Not a reliable paycheck either.

Morningstar Industry Report 2010

70%


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


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).

what is liability driven investing - fpa ny 2011

Economy & Finance

bond portfolio

bond market

bond values

unprecedented bond fund

bond fund flows40

rising rates

taxable bond funds

actual portfolio cash