Liability-driven investing (LDI) has gained popularity among family offices with more than $100 million in recent years after having been adopted by large defined benefit pension plans during the past decade. LDI can also be used for all families that have multiple needs and goals (don’t all!).
Pension funds adopted LDI as a way to match current investments to future liabilities (i.e., the future payments to pensioners) rather than trying to maximize period-to-period returns. When family offices began adopting it, they were faced with greater complexity of liabilities. Many times, the liabilities of families can be grouped into categories, for example, Lifestyle (what is needed for current and ongoing expenses of the family members), Longevity (the growth needed to meet and exceed future inflation), Liquidity (what is needed for special expenses and investment opportunities), and Legacy (what is desired for future generations and future charitable giving). Investments of the family then can be matched to the distinctly different needs within each category.
This way of thinking was less popular twenty years ago. Back then, stocks were soaring and bonds were not only paying higher interest rates but also were appreciating in value. For most investors, the focus was on total return, repeat, Return!, and both the equity and fixed income markets were delivering enough of that to meet a lot of needs.
Today, the situation is different. Bonds provide little interest, promise no appreciation and carry the possibility of future losses. Despite the equity bull market of the past six years, investors know that stocks are volatile. Pension funds and family offices have had to face the possibility that a strategy of maximizing total return might well fail to meet their liabilities.
One strategy Armor has used for retired clients has been to emphasize “stability of income” rather than “stability of principal.” With the dividend yields of many equities being greater than bond yields, investors who can meet or exceed all of their expenses with dividends can withstand the volatility of stock prices which have no impact on dividends (if they have the stomach for it).
The needs and desires of families, though, frequently are more complex than spending only their yield. Often they can be categorized with the four Ls, as described above: Lifestyle, Longevity, Liquidity, and Legacy. Liability-driven investing is a way to meet a family’s diverse needs and goals.
What does it mean to match assets to liabilities in a family? It can mean re-organizing accounts into categories that line up with the categories of needs and then re-setting the investment objectives of each category. It can also mean selecting investments that have the greatest probability of meeting the family’s goals within each category rather than attempting to maximize returns across all assets. This would have been heresy to many people twenty years ago, but not today. For example, bonds continue to be an essential component for matching current assets to future liabilities within pension plans even though most pension managers expect that bonds will provide very low returns.
One consequence of LDI is a redefinition of investment risk. The traditional definition of risk has been the standard deviation of returns from period to period over time so that a given return could be “expected” for a given level of volatility. Using this definition, stocks are higher in volatility and are expected to provide higher returns, given enough time, while cash equivalents are lower in volatility and are expected to provide lower returns. LDI replaces this definition of risk with a different one: Deviation from the satisfaction of liabilities, sometimes called liability tracking error. Using this definition, stocks are still higher-return, higher-risk investments in the context of meeting many liabilities; but cash equivalents are much more likely to be considered lower-return, higher-risk investments because of their inability to meet many needs. With LDI the risk is failure to meet a liability rather than period-to-period volatility.
If that’s too theoretical, consider this. One of our goals at Armor continues to be to help our clients identify their goals with greater specificity and then to design investment strategies to meet those goals with increased probability of success. In today’s world, sometimes trying to maximize total return on all assets can increase the risk of failure in meeting some a family’s diverse goals.