A small but growing number of advisers are starting to use something called liability-driven investing, or LDI, to create income for retirees. That's the same strategy that corporate pensions use to create income for defined benefit plan participants: One matches an asset against a future liability.
And that's how David Chapman, the head of multi-asset portfolio management at Legal & General Investment Management America, goes about building retirement-income portfolios for his clients.
"Our organization focuses our efforts almost entirely on providing secure incomes to retirees," he says. "We are a global leader in liability-driven investing, and we apply the same principals to the challenges faced by individuals approaching or in retirement that we do when we manage money on behalf of large corporate pensions."
Chapman further notes that he is "entirely sympathetic to people's desire to have an 'easy button' for retirement income. But we really feel strongly about the need to maintain diversification and hedge longevity risk in retirement, and I hope that the idea that income-focused investors should remain diversified actually brings some comfort and confidence to them."
So, what should investors with an income objective focus on now, and are there certain investments that better support that objective?
Here's what Chapman had to say:
The generally low level of yields (driven by low rates, tight credit spreads, and higher equity valuations) may make it seem difficult, if not impossible, for individuals to source a desired income now without putting future needs at greater risk.
"We absolutely agree that investors should focus on the level of income they need and the risk to that income," he says. However, focusing only on an investment's or a portfolio's yield actually introduces greater risk. For example, over the past 10 years the volatility has nearly doubled for a portfolio targeting a 5% yield that comprises of U.S. government bonds, investment-grade and high-yield bonds, and emerging market bonds. In other words, focusing only on income can actually reduce diversification (across assets and across securities within an asset class).
"Reducing diversification then also actually increases longevity risk -- the likelihood that someone will outlive their savings. There are a couple sensible ways to combat this.
"First, to provide a stable level of income, we think it's useful to focus instead on generating consistent cash flows from an investment portfolio (including from principal), and this includes a view on the potential appreciation of the invested assets in addition to the income they throw off directly.
"We think it's often overlooked that the average investment horizon in retirement is longer than people think, and time can be used to the advantage of the retirement investor. This approach leads to a more diversified portfolio where the balance can provide the stable income desired today with less risk to income needs tomorrow.
"Put another way, a focus only on higher yields places higher demands on the portfolio, which ultimately leads to lower success rates, particularly if longevity insurance isn't included.
"Longevity insurance is the second way to combat the risk of running out of savings that we alluded to earlier. Longevity insurance typically takes the form of an annuity -- something many investors are not yet comfortable with, unfortunately. However, annuities, particularly something like a deferred-income annuity, or DIA, can be an extremely effective way to reduce retirement income risk. In the case of DIAs, investors benefit from a smaller initial upfront premium while still capturing the benefits of pooled insurance."
And are there are there certain investments that better support that objective now?
Chapman says the firm does have tactically bullish views on a few investments such as emerging market (EM) bonds, Treasury-Inflation Protected Securities (TIPS), and some currencies that could provide higher yield and/or have other characteristics that might be particularly beneficial in a retirement portfolio.
"However, this is still in the context of our multi-asset framework, which relies on a broadly diversified mix and focuses on specific objectives (stable cash flows for a retirement investor in this case)," he says. "Consistent with the comments above, we certainly wouldn't advocate that a retiree concentrate their portfolio in EM bonds, TIPS, and high yielding currencies."
For more about liability-driven investing, read:
Editor's note: This is the second in our series that looks at how advisers create retirement-income plans. Read the first part, Retirement-Income Strategies: Enjoy the Journey and the Destination.
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