Friday, February 08, 2008

LDI - Lifestyle Driven Investing

January’s equity sell-off and interest rate declines sparked a resurgence in the topic of LDI or liability driven investing. LDI employs pension plan liabilities as a performance benchmark rather than the traditional total return measure using indexed assets. The fundamental argument for LDI is that real economic risk eminates from a mismatch between the correlation of a plans assets and liabilities. Correlation mismatches create volatility in Plan funding and sponsor balance sheets. Sponsors have a strong preference for stability and certainty in both these areas. The decision to seek stability has a trade-offs. The primary one is a reduction in long term returns by shifting from an equity based total return strategy to a fixed income based LDI strategy. Stability effectively costs returns. The fundamental concepts behind LDI and the stability vs. return tradeoff is equally applicable to individual retirement planning. There are at least several elements that individuals must employ to follow an LDI “lifestyle driven investing” strategy.

Identify the Liabilities – Since future liabilities are the benchmark, a good approximation must be available. Actuaries prepare these for pension plans. The plan liability analogue for an individual would be their required post retirement income need. These are the “liabilities” an individual must fund. Individuals often don’t solve the savings and investing equation for a specific required retirement income need. They simply let their retirement liabilities emerge, constrained as a byproduct of their earlier savings and investing decisions. This is backwards and inconsistent with LDI. To apply lifestyle driven investing, individuals must specify their lifestyle “liabilities” in terms of both required dollars and duration (longevity). Lifestyle Driven Investing requires starting with the end in mind.

Identify Acceptable Lifestyle Volatility - Pension plans can choose from a full spectrum of investment strategies to fund their liabilities. High equity strategies at one end of the spectrum provide the promise of lowest long term cost via the maximization of the equity return premium. The cost of this strategy can be significant funding and balance sheet volatility for the sponsor. On the other end of the spectrum, pension plans can match their liability cash-flows with corresponding fixed income assets or derivatives to effectively immunize plan surplus from changing interest rates to stabilize their funding and accounting. This reduces the volatility related to asset liability mismatches but leaves the sponsor with more out of pocket responsibility for funding the Plan.

Lifestyle Driven Investing presents similar tradeoffs in retirement distribution for individuals as pension plans face in their funding decisions. Individuals can choose a higher long term retirement lifestyle or a lower, but more certain periodic lifestyle. Equity investing will allow individuals to enjoy a higher long term post retirement lifestyle (i.e. higher average income or longer average duration) with perhaps more volatility with regard to the timing of periodic distributions. In good market years individuals can withdraw more while in poor market years individuals should withdraw less. Lower risk fixed income investing can provide more certainty around distribution patterns but at a cost of a lower average lifestyle (ie less income or shorter duration).

Lifestyle Driven Investing calculus simply suggests that certainty has cost. If individuals have more flexibility in their retirement decisions (when to retire, annual spending), they should be equity investors and can enjoy an elevated retirement lifestyle.

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