LDI Investing Is No Longer Just For Pension Funds: What It Can Do For You


Individual investors have probably heard the adage that the 60/40 portfolio is dead. There has been no shortage of articles in mainstream media about this death in the last few years. We wrote a similarly-based article about a year ago titled, "If Your Financial Advisor Has You In A 60/40 Portfolio, Run Away!"

The main reason you are seeing this today is primarily because future returns on both the bond and stock side of your portfolio will be lower. This is especially true of the bond side of your investments, which is largely predicated on the current yield when you allocate. The image below shows the problem. The 10-year bond yield in 1980 was 11.1% compared to 2.66% today.

If you have 40% of your portfolio in bonds that yield 2.66%, and equities generate 4.5%, then your 60/40 portfolio is slated to earn 3.76% per annum BEFORE advisory fees, taxes, and adding additional risk. For those investing on their own, the 3.76% (before taxes) is likely still not enough, especially if you follow the 4% withdrawal rule.

In addition to having too little in the way of future returns (at least for the next 7-10 years), we are battling sequence of returns risks. The main problem for 60/40 portfolio is when you are in distribution mode, you are slowly selling (reducing share count of positions) to meet spending needs during retirement. If 60% of your portfolio suffers a 50% decline - the S&P 500 fell ~50% in the last two recessions, peak-to-trough- and you are selling as this crash unfolds, then those shares are not there during the recovery. The results can be catastrophic for portfolio longevity (how long a portfolio will last during retirement).

To avoid this problem, we tweak the 60/40 portfolio just a bit in order to make it more acceptable for the vast majority of retirees, or soon-to-be retirees. We espouse an investing theory that essentially mimics the strategy employed by various private pensions, called Asset Liability Matching ("ALM") also known as Liability-Driven Investment ("LDI"). The popular and widely used portfolio construction technique advocated by Modern Portfolio Theory ("MPT") is not always the most practical.

What are we talking about? (Getting a little wonky here.) MPT suggests placing assets into low correlation assets to produce the most efficient portfolio on the efficient frontier. In layman's terms, this means the best return for the level of risk. Most financial advisors use the same system. And when they need income to pay a liability, they simply sell some assets and rebalance back to the target allocations.

MPT asserts that at a certain level of risk aversion, you are going to maximize your risk. The theory is right in that all else equal, if someone who has a risk tolerance of 6%, for a portfolio with a risk of 6%, they then want the highest return. The problem is that this theory ignores the other side of the balance sheet (liabilities) and how that can affect those returns. We have highlighted one of these effects in showing sequence of returns which is something that MPT essentially disregards.

The theory came into existence in the early 1950s, when the concept of retirement was a relatively new idea and even still, if someone did stop working, their retirement "career" lasted less than a decade primarily because life expectancy was much lower. Demographic trends, inflation, healthcare costs, and a host of other variables have drastically changed the idea of retirement over the last 60+ years.

This is why pension funds do not use MPT but instead use liability-driven investment strategies, also knows as ALM. ALM focuses on the other side of the balance sheet - the liabilities, both current and future. The strategy is superior when it comes to creating a portfolio for retirement needs. It is only now filtering down to the advisor/retail market, from the institutional as future returns on equities will likely be lower.

In aggregate, the ALM approach reduces total risk by focusing on those recurring liabilities. For a retiree, if you could meet your annual spending needs through the use of CDs and treasury bonds, many would. In other words, they applied the least amount of risk needed to meet their needs as opposed to the MPT approach which takes the most amount of risk tolerated. That is not to say you would necessarily invest in the treasury bonds, but it would be your starting point - from the lowest level of risk, not the greatest.

I espouse splitting the difference for most investors. If you can meet your needs for a long retirement - you should be forecasting at least to age 100- and you are content with treasury bond returns, then do it. But I prefer a system where a certain piece of the portfolio is invested in equities and other long-term growth compounders. That includes the Yield Hunting Core Portfolio that generates a roughly 8% yield where a portion of that income can be periodically reinvested.

Moving away from an asset-only approach to a strategy that considers both the assets and the specific liabilities of your retirement plan is going to be crucial over the next decade. For one, a recession is likely to occur within the next 3 years. We expect a 40%+ decline for the S&P 500, even if the recession is a mild one. As we noted earlier, this is likely to cause sequence of returns that could significantly reduce portfolio longevity. Second, by creating a portfolio that generates enough income to live on, you never have to sell anything to meet your needs. This makes you a much longer-term investor.

The ALM approach is largely a fixed income one. It tends to better match assets (through income) with liabilities (mostly spending needs). Pension funds then match duration and risk profile to the present value of those liabilities in order to reduce risk further because of timing mismatches. In addition, future inflation can eventually erode purchasing power, the offsetting of which is the primary responsibility for the long-term compounders.

We believe this will be the next big trend in financial advising. It is a more customized, outcome-oriented approach to investing. It is a way for advisors to earn their fees and combat the robo-advisor trend. Most financial advisors still today only care about the asset management portion of their responsibility - the selection of mutual funds, ETFs, and stocks to create the portfolio. They then compare that to the benchmark. Too much emphasis is placed on this portion of job description.

Ron Carson of Carson Wealth Management, one of the largest registered investment advisors in the country, states that the AUM model is worth only 20 bps. That model is when a financial advisor selects an asset allocation, selects the securities that will make up that asset allocation, and then rebalances (most often annually). We call that babysitting the assets. Most advisors still charge around 1% for that privilege.

Concluding Thoughts

Retirees want income, plain and simple. And they want it to increase with inflation. From a high-level perspective, this is fairly straightforward strategy. From a practical and implementation perspective, it can be difficult to accomplish. This is why we use a levered bond portfolio in the Core Income Portfolio. The 8% yield should produce more than enough income allowing the reinvestment of some of the yield to add to your aggregate share totals, increasing the forward payouts.

Obviously, if your portfolio is large enough, the need for an ALM approach is reduced. Even a meager 2% dividend yield can cover your liabilities means you are in a whole different world in terms of strategy. From its most basic form, ALM is derived as a bond ladder. The problem with a bond ladder today is that it locks you into the current interest rate regime. If rates rise, you've locked in the lower rates for a number of years.

Above all else, risk management is key. While our fixed income is riskier than traditional fixed income (either individual bonds or bond funds), we think it helps mitigate other types of risks which may in fact be more important. It is our contention that sequence of returns risks is one of the primary risks investors face today and could cause a retirement crisis in the near future.

Sequence of returns risk can be devastating, more so than interest rate and even credit risk to some extent. We highlight the risks in our retirement focused article, "Retirement: Sequence of Returns Risks In Retirement." For those in the de-cumulation (distribution) phase of their life, this is the most crucial risk factor to consider. If you are withdrawing 3-4% of your portfolio per year, and the typical bear market and initial recovery lasts 24 months, you just withdrew 6-8% or more of your capital at very low prices. That capital is not there for the recovery and can lead to a permanent capital loss.

For many investors, we shift their 60/40 portfolio to a 40/60 in order to reduce the equity risk enough to offset the increased volatility from the position in the Core Portfolio. By producing this extra income, we can then not only offset some of the volatility on the prices of these CEFs, but we can reduce sequence of returns risk in the process. 90%+ of pre-retirement income needs to be replaced in retirement. Generating 2% in dividend yield or treasuries is not going to cut it for most people entering or near retirement. That is where we come in.