Can liability-driven investing work for clients?

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Pensions and endowments have used liability-driven investing (LDI) for years, but is it feasible as a retirement income strategy for individuals?

At the institutional level the strategy is based on investing assets to match the present value fluctuations of future liabilities. This differs from benchmark-driven strategies which strive to achieve returns that match or beat an external index like the S&P 500.

"If you work 30 years at GM, for example, and you end up making $80,000 on average the last five years, you may have a defined benefit of, say, $1,500 to $2,000 a month," explains Jodan Ledford, head of U.S. Solutions for Legal & General Investment Management, an asset manager that specializes in fixed-income and liability-driven investment strategies for institutional clients.

"That $1,500 or $2,000 remains $1,500 or $2,000 until you die," says Ledford, who is based in Chicago. "From that perspective, there's a defined amount of assets you're receiving in perpetuity, and because there's no inflation adjustment, it's very defined," he notes. "Incorporating actuarial assumptions, pensions can estimate the future expected cash flows for each beneficiary, and then discount these cash flows to today to get a present value of the liabilities."

In a liability-driven framework, assets are then invested to minimize fluctuations between the market value of the assets and the present value of the liabilities to ensure adequate funds to pay the benefits far into the future.

“The system works well at the pension level because there’s a set of liabilities averaged over a large group of people,” says Michael Falk, CFA, a partner at Focus Consulting Group in Chicago. “If one person’s liability spikes higher, someone else’s might spike lower. The average of liabilities over the population is more predictable than the liability of one person.”

Low interest rates and year-to-year inflation also make returns for individuals more expensive to realize, Falk says.

According to Jeremy Brenn, vice president at Sensenig Capital, an RIA in Fairview Village, Pa., this type of strategy may be more suitable at the individual level with a total return approach, which would be based on price appreciation, plus dividend and bond investment income. Rather than advisors thinking solely about how much income their clients’ assets may generate, Brenn suggests they think about those assets appreciating over time as well.

“This can account for inflation because in theory,” he says, “the investment portfolio would not only generate income, but have the opportunity to appreciate in value over the long run, hence keeping pace with inflation.”

Bruce W. Fraser, a New York financial writer, is a contributor to Financial Planning.

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