By Jim Hiles
Learn more about Jim on NerdWallet’s Ask an Advisor
One of the largest and most sophisticated “investors” in the world include pensions or retirement funds that invest large amounts to provide a promised benefit for a group of employee participants. It can be argued that they use the brightest minds and most advanced research to help them achieve their desired results.
Generally, pension plans invest a predetermined amount needed to fund the promised pension at a certain time. The plan needs to calculate the amount deposited and achieve the assumed rate of return to fund the “liability” once retirement is reached. However, over the past decade of economic turmoil, the pension plans have had to deal with two significant issues — higher volatility and lower investment results than they assumed. In addition, recent economic issues have impeded their ability to fund their future liabilities. Investment committees use a method called “asset liability” matching or modeling to reduce the impact of coming up short. “De-risking” often involves allocating a larger and larger percentage to bonds. The thought-provoking question now is will “de-risking” lead us the wrong direction given the fiscal manipulation that is taking place on a global scale?
The challenge is that prior models have used static assumptions based on simulated returns from the past. The portfolio needs to change to meet the liabilities and plan committees are reluctant to do so. Will asset liability matching work in today’s market? And how can this thinking be useful to the individual investor?
Let’s start with the basics. What is asset liability matching? Simply matching an asset to pay for a future liability.
What is de-risking? De-risking is simply making changes in the allocation mix (increase bonds vs. equities) as we get closer to having a fully funded plan or the needed amount to retire on. This “glide path” can be projected and managed to evaluate progress and the likelihood of success.
As rational retirement planners, an individual should view retirement income (their financial future) as a future liability, not just a daydream of being on the beach. Personal retirement funding should be viewed as a debt much like a pension liability; a debt to ourselves that we must pay. Ironically, fewer of us will even have pensions, so personal modeling is even more paramount. We can certainly make the assumption that we should set up our “personal asset liability “model using similar institutional pension plan risk, return and cost assumptions.
Asset liability modeling uses a regression-based Monte Carlo-based simulation to generate forward looking distributions of investment allocations based on long-term risk return tradeoffs. With liability driven investing, an amount (or liability) based on future cash flow needs is determined. This financial objective is what is most important for pension plans. However, when investing for a single person vs. a statistical within a large group of people, that amount is much trickier to determine.
The simplest way of explaining the retirement glide path is to think about historical risk return trade off of equities to bonds. Generally you start with a long time horizon and therefore a higher allocation to equities. When the value reaches a certain amount (not age) you “down shift” risk by decreasing equities and increasing bonds. The probability of hitting the target related to volatility of returns is lower with equities (probability that you hit the target is called tracking error). Therefore, the downshifts in risk should improve tracking error.
The de-risking process involves forecasting to improve probabilities (emphasizing probability; not predictability). As you de-risk your way toward the amount needed to fund the liability, you can follow a glide path to investing to a funded retirement. Increasing bonds lowers tracking error and you have moved from high to low risk. Or have you?
Or has the investment world changed too much for modeling based on recent events?
The de-risking concept assumes increasing the bond allocation. The studies increasing the use of extended duration U.S. Treasuries and long-term U.S. bonds for their bond allocation create duration risk. In the world of fiscal manipulation, how much risk is there in these types of traditional bond investment and is de-risking really a trap where you become ensnared in an interest rate anomaly?
What if there is a deficit in your funding. Well, you have two choices, contribute more or take higher risk. That seems to be the message the Fed is telling us right now, isn’t it? But they can also print contributions (money) and most people can print their own or are having a hard time increasing their contributions.
One way to deal with personal pension asset liability matching is to check out your personal glide path and challenge current assumption based on irregular and unchartered market environments. We cannot predict the future but we do know that stress testing can help make appropriate changes in asset allocation. De-risking with asset liability modeling may increase the probability to produce better results through active glide path management. However, you must also understand what you are de-risking so you don’t miss your personal retirement runway.
References: Glide Path ALM. Authors: Kimberly Stockton and Anatoly Schtekman, 2012 Vanguard Research paper available at Vanguard.com.glidepathalm