Taking an institutional view of individuals’ retirement portfolios.
The Second Side
My colleagues Tom Idzorek and David Blanchett have drafted a paper called, “LDI Misapplied: Income Portfolios and Liability-Driven Investing.” That title probably doesn’t mean much to you. (If it does, please let me know, and I will use you as a consultant for future columns.) Its subject, however, is straightforward: asset allocation for retirement portfolios.
Conventional asset allocation addresses what investors own. In contrast, liability-driven investing, or LDI for short, considers both sides of the balance sheet. The assets exist for a reason, after all--to offset future expenditures. With LDI, the investor estimates those expenditures as thoroughly as possible and then attempts to hold assets that will generate cash that will pay them down. LDI is a matching exercise: It pairs assets with liabilities.
LDI got its start with defined-benefit plans. Because the plans’ future payments were specified and the aggregate life span of a group of retirees is easier to forecast than that of one person, pension managers knew almost exactly how much money they would need to disburse and when. If they could find assets that would reliably generate such cash at such times, then their plans’ needs would be addressed. Their plans would, as the parlance went, be “immunized.” (Even now, after all these years, I can’t write that word without envisioning a needle.)
The Appeal of Bonds
The solution was obvious: Treasury bonds. If the plan did not feature cost-of-living increases for its payouts, as was generally the case with corporate pensions, then the Treasuries could be mapped dollar-for-dollar to the benefits. Plans with COLA features were trickier before the invention of Treasury Inflation-Protected Securities, but, barring dramatic changes in the inflation rate--which have not occurred in recent decades--they could effectively be immunized. Then, if the plan had excess assets, besides those that were pledged to pay its debts, management could invest as it wished--which generally meant aggressively.
In summary, moving from conventional asset allocation to LDI meant that a pension plan would likely--
1) Adopt a more-conservative asset mix, by owning more bonds;
2) Prefer long to short bonds (to match the duration of the obligations, most of which were due well into the future);
3) Invest any surplus assets aggressively.