David Blanchett: Liability Driven Investing Misapplied

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
AlohaJoe
Posts: 2643
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

David Blanchett: Liability Driven Investing Misapplied

Post by AlohaJoe » Fri Nov 10, 2017 8:50 pm

(Consider this an homage to Random Walker's posts on new research.)

David Blanchett and Thomas Idzorek have a new paper on liability-driven investing (aka LMP, liability-matching portfolios): "LDI Misapplied: Income Portfolios and Liability-Driven Investing

The abstract:
Liability-driven investing (LDI)—in particular liability-relative optimization—represents a fundamental improvement over more common asset-only portfolio optimization techniques, such as mean-variance optimization. Almost all portfolios exist to pay for some future form of consumption, so liability-relative optimization is almost always more appropriate than asset-only approaches. By considering liability characteristics when solving for the asset allocation, LDI techniques take advantage of the natural hedging quality of certain investments.

Well-meaning, avant-garde practitioners have begun embracing LDI techniques when building portfolios for individual investors (especially retirees) without considering the unique characteristics of the individual’s liability or the risk attributes of the assets or cash flows retirees have available to fund the liability (e.g., Social Security retirement benefits). The result is highly conservative portfolios like those used by institutional investors. But these investors tend to have more predictable liabilities, with idiosyncratic risks leveling out across a large population of retirees.

Individual investors are subject to greater idiosyncratic risk in their retirement spending needs, and must also invest appropriately to hedge risk in an LDI context. Importantly, individuals have greater flexibility in retirement spending, in part because retirement expenses aren’t a legal liability, and because many have other ways to pay for retirement expenses, including other assets, Social Security retirement benefits, and the ability to work during retirement. After investigating better ways to properly model investor expenses, we find that most investors at or near retirement are likely better served with less conservative, more balanced, and more diversified portfolios that recognize the increased duration associated with living longer.
They have (IMHO) three main take aways for those considering an LMP approach to planning their retirement.

1. Ignoring liabilities (which traditional planning does and LMP tries to fix) has a huge effect on portfolio design.
2. How you model a retiree's liabilities has a huge impact on portfolio design.
3. Ignoring the retiree's full balance sheet (Social Security, home equity, buying an annuity, etc) has a large impact on portfolio design.

Here's a quick look at each of the 3.

Ignoring liabilities results in a very different portfolio than one that accounts for them.

Here's a traditional efficient frontier and here's one that assumes you have a future liability.

Image

Notice that on the right hand side, for the most aggressive investors, things look identical. But as you move to the left, the portfolios begin to look very different. The main point is that unless you are a very aggressive investor, taking liabilities into account will result in a very different portfolio design.

How you model liabilities has a huge impact

Individual investors have a significant disadvantage when it comes to building an LMP: they need to model their future liabilities and they are subject to massive idiosyncratic risk. Insurance companies and pension funds don't have that problem because the law of large numbers means all of the idiosyncratic risk is balanced out.

This is exactly the same reason all of us eschew individual stocks and prefer indexes. But building an LMP for yourself is a bit like investing in a single stock.

Exactly how you model those future expenses will have a large impact on the portfolio you design. The authors show 3 different models of liability and their affect on asset allocation.

Image

With one model, you should have 89% of your portfolio in long (nominal) bonds. With another model only 1.9% in long (nominal) bonds but 18.7% in short term TIPS and 12.9% in global high-yield bonds.

Take the full balance sheet into account

In the real world people have Social Security. They may have a pension. They can buy an annuity if they want. They may have home equity. It has long been known that those things affect asset allocation and that continues to hold true when using a liability-driven approach.

Here is an example of a liability-driven asset allocation that ignores Social Security and another one that assumes Social Security makes up 40% of your retirement income.

Image

Again, on the right side, the most aggressive side, they are identical. But as you become more conservative they diverge.
Security retirement benefits are incorporated into the portfolio optimization the allocation TIPS (both short and long) changes to zero for even the most conservative portfolios. Therefore, while some academics have contended that TIPS are the optimal hedge against the retirement liability, we find that the true benefit of TIPS is likely significantly less when viewed from a more holistic perspective.

User avatar
Taylor Larimore
Advisory Board
Posts: 26252
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

"Smart investing is non-mathematical and accessible to everyone"

Post by Taylor Larimore » Fri Nov 10, 2017 9:08 pm

Bogleheads:

Consider the words of Michael Edesess, author of The Big Investment Lie:
"As a mathematician I know when mathematical-sounding analyses are little more than elaborate sales pitches, designed to thoroughly obscure the simple fact that smart investing is non-mathematical and accessible to everyone."

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

Dottie57
Posts: 2405
Joined: Thu May 19, 2016 5:43 pm

Re: David Blanchett: Liability Driven Investing Misapplied

Post by Dottie57 » Fri Nov 10, 2017 9:09 pm

I find the color bands very distracting and wonder what exactly is the difference between the colors.

User avatar
saltycaper
Posts: 2210
Joined: Thu Apr 24, 2014 8:47 pm
Location: The Tower

Re: "Smart investing is non-mathematical and accessible to everyone"

Post by saltycaper » Fri Nov 10, 2017 11:41 pm

Taylor Larimore wrote:
Fri Nov 10, 2017 9:08 pm
Bogleheads:

Consider the words of Michael Edesess, author of The Big Investment Lie:
"As a mathematician I know when mathematical-sounding analyses are little more than elaborate sales pitches, designed to thoroughly obscure the simple fact that smart investing is non-mathematical and accessible to everyone."

Best wishes.
Taylor
Why do you think this is a veiled sales pitch rather than a substantive analysis on factors influencing asset allocation? Because it includes math? That is a remarkable assertion.

The article's main conclusion seems to be that modeling individual investor LDI portfolios on the portfolios of pension funds causes overly conservative portfolios if differing liability characteristics are not taken into account. What is it about their methods and findings that causes you to disagree? The use of charts and figures?
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

dcabler
Posts: 312
Joined: Wed Feb 19, 2014 11:30 am

Re: David Blanchett: Liability Driven Investing Misapplied

Post by dcabler » Sat Nov 11, 2017 7:45 am

Dottie57 wrote:
Fri Nov 10, 2017 9:09 pm
I find the color bands very distracting and wonder what exactly is the difference between the colors.
If you click on the link in the first post, you'll get the paper itself - same pictures, but the color bands are defined.

DaufuskieNate
Posts: 222
Joined: Wed May 28, 2014 11:53 am

Re: David Blanchett: Liability Driven Investing Misapplied

Post by DaufuskieNate » Sat Nov 11, 2017 10:34 am

Thank you, AlohaJoe, for posting a link to this article and giving us some very well thought out observations. There are some very solid points made in the article. Here are a few that I think will resonate with Bogleheads:

1) When inflation has an impact on future consumption, cash is no longer a risk-free asset.

2) Individual retirement cash flows can be somewhat volatile, and retirees often have some degree of flexibility with respect to spending. Institutional pension funds actually face less volatile cash flows as obligations are more fixed and mortality is evened out with large numbers of participants. This suggests that the portfolio that is appropriate for an individual may look quite different than one designed for a pension fund.

3) Risk is not fully captured with a simple measure of volatility. Asset returns do not follow a normal bell curve and "left-tail risks" need to be considered.

4) An investment strategy that is focused on future liabilities often leads to a degree of home country bias.

5) Social Security benefits should be incorporated into asset allocation decisions. Doing so often reduces the relative attractiveness of TIPS.

This is a serious article that is exactly the kind of material that many of us look for in a forum devoted, in part, to investment theory. The authors are from Morningstar and the primary audience seems to be practitioners. There are 19 references to other articles from serious publications such as the Journal of Portfolio Management. If there is a hidden sales pitch, I couldn't detect it. Although, I am impressed that someone could read this 34-page article, digest it, find the sales pitch that I couldn't find, and post on it 18 minutes after the original post.

dbr
Posts: 24197
Joined: Sun Mar 04, 2007 9:50 am

Re: David Blanchett: Liability Driven Investing Misapplied

Post by dbr » Sat Nov 11, 2017 11:18 am

It may take some time to digest this paper and decide how applicable the conclusions are to ordinary retiree/investors such as some of us.

That said, I have always been concerned that the much presentation of the LMP concept is overly simplistic and naive and may constitute more mental accounting than be a real difference in how to invest in retirement. But it is not always that easy to really understand the meaningful consequences of one view over another.

The point that stands out for me in the comments and brief quotes from the paper is that individual retiree expenses are volatile and idiosyncratic and that fact is the first one that jumps out in my mind that makes LMP more difficult to embrace. It is also true that for many retirees there is income other than from the portfolio that theoretical consideration of LMP methods may not be taking into practical account.

pkcrafter
Posts: 12172
Joined: Sun Mar 04, 2007 12:19 pm
Location: CA
Contact:

Re: David Blanchett: Liability Driven Investing Misapplied

Post by pkcrafter » Sat Nov 11, 2017 12:24 pm

dbr wrote:
Sat Nov 11, 2017 11:18 am
It may take some time to digest this paper and decide how applicable the conclusions are to ordinary retiree/investors such as some of us.

That said, I have always been concerned that the much presentation of the LMP concept is overly simplistic and naive and may constitute more mental accounting than be a real difference in how to invest in retirement. But it is not always that easy to really understand the meaningful consequences of one view over another.

The point that stands out for me in the comments and brief quotes from the paper is that individual retiree expenses are volatile and idiosyncratic and that fact is the first one that jumps out in my mind that makes LMP more difficult to embrace. It is also true that for many retirees there is income other than from the portfolio that theoretical consideration of LMP methods may not be taking into practical account.
+1

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

CULater
Posts: 503
Joined: Sun Nov 13, 2016 10:59 am

Re: David Blanchett: Liability Driven Investing Misapplied

Post by CULater » Sat Nov 11, 2017 12:51 pm

Nothing to tricky or difficult to understand about Liability Based Investing, IMO. Let's not make this overly complicated. The idea is to spend some time and effort to determine what one's financial "liabilities" are, both present and possible future liabilities. A liability is defined as a financial debt or obligation for which one is responsible. First level liabilities are known, fixed current financial payments that must be met, such as housing expense, utilities, car payments, fuel, provisions, clothing, health - the kind of stuff you need to stay sheltered and alive. One must consider current liabilities and plan ahead to anticipate and optimize future liabilities, such as housing and healthcare.

To the best of one's abilities, basic liabilities should be secured by the safest liability-matching assets and income streams available. This would include pensions, annuities, and social security, and if these are insufficient then assets such as TIPs, CD ladders, Short-term bond ladders, should be considered. Most desirably, inflation-protected assets should be employed.

Just because it's hard to conduct a valid liability audit and it's hard to accurately anticipate future liabilities doesn't provide an excuse for not doing it. That's how businesses are run, and running your retirement should be run in a sound business-like fashion, or it will go bankrupt; and that's what liability-based investing is all about, IMO. Not that difficult to grasp.
May you have the hindsight to know where you've been, The foresight to know where you're going, And the insight to know when you've gone too far. ~ Irish Blessing

User avatar
bobcat2
Posts: 4960
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

Robert Merton: Liability Driven Investing Correctly Applied

Post by bobcat2 » Sat Nov 11, 2017 12:58 pm

Robert Merton: Liability Driven Investing Correctly Applied

Link to article, Applying life-cycle economics - http://www.nestpensions.org.uk/schemewe ... cs,PDF.pdf
Summary
The discussion above presents an income target oriented (LDI) approach to DC both pre- and post-retirement. It is designed to achieve the following.

• It integrates income drawdown and annuitisation in a coherent fashion.

• Conceptually, it provides a seamless transition from accumulation to decumulation, by setting goals and defining risk in income terms, and providing very similar choices.

• It provides a customised solution for each member.

• It provides an integrated perspective on other sources of retirement income, such as state benefits, DB pensions and working after retirement.

• It provides a member experience in retirement that is very similar to the experience pre-retirement.

• By using a liability-driven investment (LDI) approach both pre- and post retirement, it reduces interest risk while reducing the need for annuitisation, and allowing the member to delay his payout decisions until very close to retirement, when he is best informed and motivated to make such decisions.
BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

User avatar
Taylor Larimore
Advisory Board
Posts: 26252
Joined: Tue Feb 27, 2007 8:09 pm
Location: Miami FL

Re: David Blanchett: Liability Driven Investing Misapplied

Post by Taylor Larimore » Sat Nov 11, 2017 1:12 pm

I am impressed that someone could read this 34-page article, digest it, find the sales pitch that I couldn't find, and post on it 18 minutes after the original post.
DaufuskieNate:

Thank you for the compliment. :happy

David Blanchett, who co-wrote the article, is head of Morningstar Investment Management LLC which is launching new funds for the exclusive use of Financial Advisors to sell their clients. What better "sales pitch" than "Liability Driven Investing" (also called "Cash Matching" and "Dedicated Portfolio Theory").

Morningstar Makes Bid to Offer Mutual Funds for Exclusive Use of Advisors \
Jonathan Clements, Wall Street Journal columnist: "Investing is simple. To be sure, you can make it ludicrously complicated."
Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

CULater
Posts: 503
Joined: Sun Nov 13, 2016 10:59 am

Re: David Blanchett: Liability Driven Investing Misapplied

Post by CULater » Sat Nov 11, 2017 1:19 pm

Thanks BobK. Merton's approach makes a lot more sense to me than the OP's linked article, which is far too convoluted and all wrapped up with Monte Carlo simulations and statistical abstractions. Gee, maybe good for a financial advisor who wants to obfuscate clients and impress them but certainly not DIY by any stretch.
May you have the hindsight to know where you've been, The foresight to know where you're going, And the insight to know when you've gone too far. ~ Irish Blessing

User avatar
SimpleGift
Posts: 2671
Joined: Tue Feb 08, 2011 3:45 pm
Location: Central Oregon

Re: David Blanchett: Liability Driven Investing Misapplied

Post by SimpleGift » Sat Nov 11, 2017 2:51 pm

There's a lot to think about in this excellent paper (thanks, AlohaJoe) — but this is a key takeaway from my perspective:
Morningstar wrote:After investigating better ways to properly model investor expenses, we find that most investors at or near retirement are likely better served with less conservative, more balanced, and more diversified portfolios that recognize the increased duration associated with living longer.
This certainly fits with our own retirement portfolio design and our personal approach to retirement spending.
Cordially, Todd

User avatar
saltycaper
Posts: 2210
Joined: Thu Apr 24, 2014 8:47 pm
Location: The Tower

Re: David Blanchett: Liability Driven Investing Misapplied

Post by saltycaper » Sat Nov 11, 2017 3:08 pm

Taylor Larimore wrote:
Sat Nov 11, 2017 1:12 pm

David Blanchett, who co-wrote the article, is head of Morningstar Investment Management LLC which is launching new funds for the exclusive use of Financial Advisors to sell their clients. What better "sales pitch" than "Liability Driven Investing" (also called "Cash Matching" and "Dedicated Portfolio Theory").

Morningstar Makes Bid to Offer Mutual Funds for Exclusive Use of Advisors \
Jonathan Clements, Wall Street Journal columnist: "Investing is simple. To be sure, you can make it ludicrously complicated."
Best wishes.
Taylor
You are casting aspersions on someone's work without evaluating the merits of their arguments nor, apparently, even attempting to understand what they are saying.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

Levett
Posts: 4177
Joined: Fri Feb 23, 2007 2:10 pm
Location: upper Midwest

Re: David Blanchett: Liability Driven Investing Misapplied

Post by Levett » Sat Nov 11, 2017 3:14 pm

Really regrettable comments, Taylor.

In logic, you have committed the most basic error: argumentum ad hominem.

Read on: http://philosophy.lander.edu/logic/person.html

Lev

User avatar
Artsdoctor
Posts: 3023
Joined: Thu Jun 28, 2012 3:09 pm
Location: Los Angeles, CA

Re: David Blanchett: Liability Driven Investing Misapplied

Post by Artsdoctor » Sat Nov 11, 2017 3:56 pm

Blanchett offers reasonable points, with one of them being the downward push of the overall portfolio toward the "overly conservative" side. This is true.

I don't think that a Liability Matching Portfolio is for everyone. I also would not advocate that the vast majority of any portfolio is an LMP for many of the reasons Blanchett lists. However, I do find that having a LMP to meet basic needs is comforting (albeit expensive).

As Blanchett points out, interests and priorities often change during a brutal bear market. We've had a very long bull market now so time will tell how people cope with another bear market as well as an increasing rate environment--at the time of retirement.

CULater
Posts: 503
Joined: Sun Nov 13, 2016 10:59 am

Re: David Blanchett: Liability Driven Investing Misapplied

Post by CULater » Sat Nov 11, 2017 5:23 pm

I agree with Taylor.
May you have the hindsight to know where you've been, The foresight to know where you're going, And the insight to know when you've gone too far. ~ Irish Blessing

Post Reply