The latest concern of many clients, fuelled by politicians and others, is whether people saving for retirement have too much exposure to equities and not enough to bonds. Ordinarily one could say that that is a question best left to professionals.
The evidence is unassailable: over very long periods – say 20 –year data points for the past 150 years (you can actually only do such a long time with US data) – equities have outperformed bonds, cash and property by at least 3 percentage points. So, if a person is 20 years off retiring and another 20 years off dying, on average, he or she should have a big exposure to equities. No question.
Well, some professionals operating in a slightly different framework have already been questioning that for the past several years – well before the global financial crisis. These are the sponsors of defined benefit pension plans in the UK and US who have moved en masses to Liability Driven Investment (LDI) strategies. Perhaps, just perhaps, Australian planners should take note for some of their clients.
An LDI strategy takes a totally different approach to designing an appropriate investment portfolio. It does not try, simply, to make the most money for the least risk for the client given all the relevant factors of age, health and so on. It maps out the known and expected cash requirements to cover the legal liabilities of the fund (pensions) and then puts together a no-risk investment portfolio to ensure they are covered. In this way, the fund acts more like an investment banker than a funds manager.
LDI investing is an ultra-conservative way corporations with worker pension liabilities have limited their downside. The company or plan sponsor has given up on trying to make money out of the market to cover future liabilities. It has, instead, built a portfolio to almost-guarantee the bare minimum required. In today’s corporate world, near enough is good enough.
The main point for Australian planners is that a pure LDI strategy will usually include NO equities. It can still be quite a sophisticated portfolio with inflation bonds and various hedges in place for its sovereign bonds, high-yield and other debt securities, but it has NO equities.
Here’s an example set by the staff pension fund of a large European bank, Deutsche Bank:
The Deutsche Bank’s staff fund, with about $US12 billion in assets and 101,000 employees, has phased in its LDI program over the past 10 years. The bank decided that to have a traditional pension plan investment strategy held too much risk, given that the bank had undertaken to pay many workers on a defined benefit basis (guaranteeing a certain level of pension depending on salary levels in the final years of employment).
So, very gradually, the fund moved away from what was roughly the German norm of 50 per cent bonds and 50 per cent equities to an asset allocation of: 10 per cent bonds, 70 per cent “spread” products and 10 per cent equities and alternatives. The “spread” products include: emerging market bonds, European corporate bonds, ESG (environment, socially responsible and governance) corporate bonds, US high-yield bonds and long-duration credit ETFs. The 10 per cent growth assets allocation of equities and alternatives is seen as a total alternatives bet, with no concern for diversification within the equities portion. Overlayed across the total portfolio are three swaps to further contain risk: a credit default swap, interest rate swap and inflation-linked swap.
Now the past 10 years have covered some unusual and turbulent times but the end performance, since the changes started being implemented in 2002, is worth noting. The Deutsche staff fund has a 10-year annualised average return of 7.34 per cent with a monthly volatility of 7.12 per cent, as of February 2012.
No planners will have a client with $10 billion to implement such a strategy, but components of the LDI philosophy are worth considering in order to inject some rationality and sophistication into the current debate. It’s actually not about bonds versus shares. It’s about a building a portfolio targeting a defined outcome.
