Total return vs. Asset-liability matching

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Robert T
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Total return vs. Asset-liability matching

Post by Robert T »

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Should we be learning more from pension plan investment frameworks?

Pension plans often use an asset-liability matching investment framework or a blend of total return and asset-liability matching. Here’s a comparison of the two approaches (from an earlier Vanguard article http://www.vanguard.com/international/c ... mentEN.pdf ).

Total return: Application of modern portfolio theory. “Mean-variance optimization is often used to determine asset allocation that’s expected to provide highest risk adjusted return.”

Asset-liability matching: More explicit focus on ensuring assets are sufficient to pay liabilities at a point in time.

Code: Select all

Two paradigms

-------------------------------------------------------------------------------
                     |  TOTAL RETURN              |   ASSET-LIABILITY 
                     |                            |   MATCHING
-------------------------------------------------------------------------------
Rationale            |  Pension funds are         |   Asset objective         
                     |  long-term investments.    |   linked explicitly  
                     |  Over time, assets will    |   to funding pension 
                     |  outperform liabilities.   |   benefits.
-------------------------------------------------------------------------------
Objective            |  High long-term asset      |   Stable funding status
                     |  return                    |
-------------------------------------------------------------------------------
Risk measure         |  Volatility of return      |   Volatility of funding
                     |                            |   ratio
-------------------------------------------------------------------------------
Risk-free asset      |  Cash                      |   Fixed income portfolio
                     |                            |   perfectly matched to 
                     |                            |   cash flows of liabilities  
-------------------------------------------------------------------------------
Correlation          |  Maintain portfolio of     |   Maintain portfolio of
                     |  assets with low           |   assets positively
                     |  correlation to one        |   correlated with present
                     |  another                   |   value of plan liabilities
-------------------------------------------------------------------------------
Liabilities          |  Are outperformed          |   Are matched
                     |                            |
-------------------------------------------------------------------------------
Model                |  Efficient frontier or     |   Model liabilities, match
                     |  CAPM                      |   liabilities with asset
                     |                            |   portfolio
-------------------------------------------------------------------------------

Source: Pension Plan Issues: Investment Framework. Vanguard (see above linked article).

On personal investments, Zvi Bodie’s suggestion seems to fall in the asset-liability matching framework (i.e. stick with TIPS and match their maturity to future liabilities). The more common suggestions fall into the total return framework (mean-variance efficiency). Some approaches use a blend of both (as suggested in the article) i.e. with a portion of a portfolio, match fixed income maturity to liabilities, and with another portion use a total return approach.

Any views?

Robert
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Rodc
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Post by Rodc »

I have to dash out at the moment and will read the article when I return.

But, this has been on my mind for a while in a vague way so I look forward to the read.

Off hand I would say that early in your accumulation you don't know enough about how the future will unfold to do much liability matching and so total return ideas would seem to naturally dominate.

But as you move closer to retirement, you know your likely career trajectory, earning etc, you know when college for kids will come due, you know your mortgage, etc etc, you can move more towards a liability matching scheme.

By the time you are well into retirement it may make sense to be totally over on the liability matching side, especially if money is a little tight. If you are in part investing for heirs you may well still want to be partly on the total return side of things.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Post by G-Money »

Nice article. I was thinking about advising my parents on the sort of blended strategy Robert T mentioned at the end of his post: buy individual TIPS sufficient to fund each year of retirement (less SS and any pension benefits), and with any excess, invest for total return (maybe using Swenson's recommended portfolio of 30% US stock, 20% foreign stock, 20% REIT, 15% TIPS, 15% Nominal Treasuries). Each year, sell some of the total return portfolio and buy another year's worth of TIPS. Not the most exciting portfolio, but it would certainly pass their "sleep test."

I'm a big fan of this idea. As this latest downturn is showing, investors seem to be less risk tolerant than they fancied themselves in headier times. Workers who are x years from retirement (x being a number between 0 and 20) would have 20-x years worth of retirement already squared away. The remainder would be invested for the long-term, i.e., more than 20 years. Investors with more than 20 years to retirement would be entirely invested for total return.

Since I've got more than 20 years until retirement, I'm comfortable with implementing an all total-return portfolio, but I'm strongly considering adding a liability-matching component when I get to be 19 years out.
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Post by G-Money »

I did find it interesting that the article seems to ignore the possibility of using TIPS. It discussed the risk of inflation, but doesn't even mention the idea that TIPS could protect the pension from this risk.

Also thought the discussion of the "prudent man" rule was interesting. One would think that any pension that exactly matched its liabilities with assets sufficient to meet those liabilities would be considered a prudent fiduciary. Maybe the pension plan could have made more money investing differently, but not without taking on the risk of failing to meet its liabilities. I'm reminded of nisiprius's posts about how the risk of something outperforming TIPS isn't really a risk per se (i.e., it's not a risk of failure), but merely a risk of "gee, someone who invested in something else came away with more money than me." I think most people can handle that kind of risk.
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alec
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Post by alec »

Unfortunately, there aren't really financial products out there that allow me to match my retirement liabilities. For example, there are no zero-coupon TIPS with 30-80 years until maturity. Also, other than my pension plan, which isn't portable, there's no one saying "if you give me X now, I'll give you Y dollars per year when you retire." See Where's the beef?

However, for college, there are such financial products - pre-paid college tuition plans, collegesure CDs, etc. They mature exactly when my kid goes to college. Unfortunately, I don't think there's a plan like this that will cover all my kids' college expenses other than tuition and possibly room and board. What about food, books, etc?

- Alec
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Post by G-Money »

alec wrote:Unfortunately, there aren't really financial products out there that allow me to match my retirement liabilities. For example, there are no zero-coupon TIPS with 30-80 years until maturity. Also, other than my pension plan, which isn't portable, there's no one saying "if you give me X now, I'll give you Y dollars per year when you retire." See Where's the beef?

However, for college, there are such financial products - pre-paid college tuition plans, collegesure CDs, etc. They mature exactly when my kid goes to college. Unfortunately, I don't think there's a plan like this that will cover all my kids' college expenses other than tuition and possibly room and board. What about food, books, etc?

- Alec
Well, there's nothing perfect. But try not to let the perfect be the enemy of the good.

You can get 20 year TIPS. Starting when you're 19 years from retirement, buy them each year, in an amount sufficient to fund your retirement for a whole year. Anything that's not in TIPS will need to be invested for total return (stocks & bonds, whatever AA you want). While it's not as safe as TIPS, you can at least know that you won't need to touch the total return money for 20 years, which is pretty long-term by most definitions.

I'm still chewing on this, so take the above FWIW.
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Post by nisiprius »

Just speaking personally, without theory and from my own common sense, it's always seemed just plain common sense to me to match assets and liabilities. There's a good article, Robert Kreitler, Retirement Planning/November–December 2002, Tools and Pools, which someone, I think bob90245, put me onto, that describes the kind of thinking I'd already been doing.

For example, I have four annual premium payments left to make on my long-term-care insurance. As far as I'm concerned, it's essential that I make them... so I've carved out $25000 from the conservative part of my portfolio and earmarked it to deal with this. Match asset to liability, take both off the table, and then think about dealing with what's left.

What happens is you first factor out the most predictable and most certain expenses and match them with the most predictable and most certain sources of income. When what's left starts to be too impossible to plan, that's where you throw up your hands, cross your fingers, and say "time and chance happeneth to all."

I think it makes more sense to project the bedrock-essential expenses, which I'll define as food, clothing, shelter, health insurance, and one car, and carve out a certain part of the portfolio whose job it is to take care of these. You don't fool around with stocks in that part of the portfolio. One of the reasons I bought an SPIA at a rather young age is that it's clear that I basically have a nearly-irrevocable commitment of part of my portfolio to meet expenses that exceed Social Security, so it doesn't seem terrible to take care of them by making a truly irrevocable commitment to an SPIA. I'd have to use that part of the portfolio for boring stuff like paying the electric bill anyway. It's just not available for rebalancing or anything else.

The arithmetic all has to come out the same in the end, but I think the mental bookkeeping is clearer if you have a specific answer to the question "from where, specifically, in my portfolio, is my next meal coming?" than if you just sorta say "this big blob of assets generates this somewhat turbulent flow of income, and it's probably going to be enough to cover both food and iPods." Buy food out of Social Security and SPIAs and bond interest, buy iPods out of stock market growth.

(Truth-in-advertising: in reality my planning is far more impulsive and chaotic than the above would suggest!)
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Post by alec »

G-Money wrote:
alec wrote:Unfortunately, there aren't really financial products out there that allow me to match my retirement liabilities. For example, there are no zero-coupon TIPS with 30-80 years until maturity. Also, other than my pension plan, which isn't portable, there's no one saying "if you give me X now, I'll give you Y dollars per year when you retire." See Where's the beef?

However, for college, there are such financial products - pre-paid college tuition plans, collegesure CDs, etc. They mature exactly when my kid goes to college. Unfortunately, I don't think there's a plan like this that will cover all my kids' college expenses other than tuition and possibly room and board. What about food, books, etc?

- Alec
Well, there's nothing perfect. But try not to let the perfect be the enemy of the good.

You can get 20 year TIPS. Starting when you're 19 years from retirement, buy them each year, in an amount sufficient to fund your retirement for a whole year. Anything that's not in TIPS will need to be invested for total return (stocks & bonds, whatever AA you want). While it's not as safe as TIPS, you can at least know that you won't need to touch the total return money for 20 years, which is pretty long-term by most definitions.

I'm still chewing on this, so take the above FWIW.
Don't worry, I'm definitely with you on this one. TIPS are better than nothing.

btw - does anyone else think nisiprius is actually Bodie in disguise? :wink:
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alec
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Post by alec »

nisiprius wrote:Just speaking personally, without theory and from my own common sense, it's always seemed just plain common sense to me to match assets and liabilities. There's a good article, Robert Kreitler, Retirement Planning/November–December 2002, Tools and Pools, which someone, I think bob90245, put me onto, that describes the kind of thinking I'd already been doing.
Another good article is from David Babbel at Wharton:

Investing your Lump Sum at Retirement

See the recommendations beginning on page 5.

- Alec
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Post by bob90245 »

nisiprius wrote:Just speaking personally, without theory and from my own common sense, it's always seemed just plain common sense to me to match assets and liabilities. There's a good article, Robert Kreitler, Retirement Planning/November–December 2002, Tools and Pools, which someone, I think bob90245, put me onto, that describes the kind of thinking I'd already been doing.
I agree, it is a good article. PDF file can be accessed here:

http://bobsfiles.home.att.net/Kreitler_article.pdf

... as part of a collection of other articles on withdrawal strategies:

http://bobsfiles.home.att.net/MoreWithdrawLinks.html
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Post by ken250 »

Isn't this what duration is all about?
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Post by Robert T »

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Rodc, I tend to agree with you – a shifting approach seems to make sense.

G-Money, I think TIPS are a better choice at matching real liabilities than nominal bonds

nisiprius, I like the idea of having certainty in income to match certain expenses in retirement. A liability-matching approach for these expenses seems to lowering the dispersion of likely outcomes, than a total returns approach. Just my view.

ken250, yes. But there’s a difference between individual bonds/TIPS and bond funds IMO. Individual bonds mature so bond maturity can be matched to liabilities (if trying to implement a liability matching approach). Bond funds don’t mature (they have fairy constant duration).

Robert
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Post by dumbmoney »

Human beings, unlike pension plans, don't have fixed liabilities (either nominal or real).

However, one can choose to place a "hard floor" on investment income by investing in an annuity or TIPS ladder (without rebalancing). With a constant-mix portfolio, there is no lower bound on the investment return regardless of stock/bond ratio.

Perhaps the most effective form of hedging is to own your own home. This perfectly matches an asset (a home) with a major liability (need for housing)...assuming you never move!
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ken250
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Post by ken250 »

RobertT,

I agree, with funds it's like hanging the carrot in front of the horse and the horse thinks he's actually going to catch the carrot :shock:

If you look at duration in terms of when you expect you're going to "get all your money" it seems individual issues are safer because you can match duration and liabilities closely; however, funds are highly diversified...which leads to the obvious conclusion that institutions with defined obligations are only using the highest quality bonds.
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