How does Liability Driven Investing Work?

Liability Driven Investing may sound academic and complex, but in practice it’s extremely straightforward. At its core, Liability Driven Investing means that you invest money that you will need in 3-5 years differently than money that you will need in 20 years.

By identifying when you will need the money, you can then design the best investment portfolio to help you reach that goal in the most efficient manner possible.  Sound interesting? Then read on!

Prefer to watch rather than read? Check out the video below:

Where does Liability Driven Investing Come from?

Liability driven investing’s most famous practitioners may not spring immediately to mind, but the largest investment institutions in the world all practice it.

Who might those institutions be, you may ask?

Pension plans. At their very core pensions are funded and invested to meet the payments they will owe in the future… aka their liabilities! Liability Driven investing takes those same institutional quality investment strategies and applies them to your personal financial planning.

So how does Liability Driven Investing work?

In a world where investment time frames are shorter than ever and people are chasing the latest and greatest trend; there’s value to be gained from the clarity of understanding exactly how and why you should invest. Doing this through the lens of liability driven investing is, in my opinion, the smartest way to go about this. To create a liability driven investment plan, you need to start by asking the right questions:

1. How much money is required to successfully fund this goal?
2. When do we need the money?
3. What rate of return can we expect over this time period?

Once you know the answers to questions one and two, question three informs the design of your investment portfolio. The beauty of liability driven investing is that by knowing your timeframe and your goals, you can build realistic expectations for your portfolio and understand when taking risk is appropriate and when it’s not.

Why do you utilize liability driven investing?

Let’s look at these two goals:

1. Need $50,000 for a down payment in the next 2 years
2. Need $3,000,000 in 30 years to retire

Should these be invested the same way?

Not only, would we say no, but the math agrees as well. When constructing a portfolio, the first and most important consideration is when you need the money. Too often I see one of two things.

1. People who have all of their savings invested in the stock market
2. People who have all of their savings sitting in cash

While those are completely different, they are both misguided.

Why is that misguided?

Here’s a chart that shows the period of negative returns for the SP500 since 1950.

Historic Market Returns

As you can see, the SP500 had a negative return ~26% of the time over a 1-year time period. However, the SP500 had a positive return 100% of the time over a 15-year time period!

Here’s what this would mean for the short-term goal –

1. Let’s say you planned to save $25,000 per year for 2 years to meet your $50,000 down payment. If, after year 1, the market was down 20%, then you would only have $20,000 in your account. If this were to happen, you would need to make an additional $5,000 deposit in year 2, leading to a total cost of $55,000 for your $50,000 down payment!
2. If instead, you opted to invest conservatively into short-term Treasurys at 4% over that 2-year time frame, you would have $26,000 at the end of year 1. Accounting for the yield, you would only need to invest another $22,077 at the start of year 2 to reach your goal. If this were to happen, you would spend $47,077 to reach your $50,000 down payment.

This is a safer route, but unless you are willing to delay purchasing your home if the market goes against you, there is a FAR higher chance of success in achieving your goal on your timeline.

On the flipside, let’s explore the difference in investing safely versus taking some risk and investing long-term in the equity markets for the person pursuing retirement.

1. Let’s say you invested $50,000 per year for 20 years to save towards retirement, but you refused to take risk and invested in Treasury Bills only and received a 4% return over that period. Inflation increased at 3% over that same period. At the end of the period, you would have $1,488,904. At a 4% withdrawal rate that would give you $59,556 per year in retirement income.  However, due to inflation, $59,556 would only be worth $32,974 on today’s dollars!  While you did well by saving that money, the question is “What did you potentially give up?”
2. In the second scenario, let’s assume that you invested the same $50,000 per year for 20 years. Instead of investing in Treasury bills, you invested in the stock market and received an 8% return. At the end of the period, you would have $2,288,098. At a 4% withdrawal rate that would give you $91,523 in retirement income. After adjusting for inflation at 3%, that would be $50,674. That is an almost 54% increase in income!

While the stock market is perceived as risky, I believe that is mostly due to its short-term fluctuations. After you look at those long-term numbers where it has never been negative in 15 years, what is the larger risk? The fluctuations in the market or having significantly less income once you retire?

This backs up our intuition that tells us that it makes sense to invest our longer-term money in the market to meet our longer-term goals, while we invest towards short-term goals in a safer manner.

Need that money for your down payment? Separate it out into a different account and invest it with a distinctly different strategy from your other, longer-term goals.

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How do I create the actual portfolio when utilizing liability driven investing?

The next step in liability driven investing is constructing the portfolio. What components do we use to reach these outcomes?

While there are hundreds of different methods and actual portfolio approaches, I am going to use the simplest version here.

What you see below is a chart from JP Morgan’s guide to retirement that reviews some possible paths forward.

What you can see in the above chart is the range of historic returns for 4 possible solutions:

1. Stocks
2. Bonds
3. 50/50 Stocks & Bonds
4. Cash/T-bills

This reinforces what we discussed earlier about how equities are the most volatile in the short-term with almost 3x the downside of the next option! However, look at the long-term – where they have both the highest ceiling and the highest floor!

When setting your planning expectations, here are a few ideas –

1. For short-term goals, use the guaranteed interest rate over the period you are using. If you’re using a 1-year goal, use a 1-year treasury bill. If you’re using a 3-year timeframe, use the interest rate and invest in a 3-year bill. This is the simplest way to meet your goals.
2. For long-term goals, you have two options, use the long-term average return of stocks, or use the lowest return over that same time period. For example, the long-term minimum in the chart above is 6%. If you wanted to be conservative, you could use that instead of the average historical return which has been 9.89% over the last 30 years.

In the chart below, you will see how our liability driven investment portfolios are typically set up.

What this chart shows is the percentage of the account invested in the stock market based on the years remaining. As you can see, the percentage increases the further out your goals are.

Rather than have all clients invested the same or in just one portfolio to accomplish several goals, we set-up separate portfolios to help them match their actual liability and timeframe.

We typically take this approach – no market risk and all cash or treasury bills for all goals within 5 years. This can reduce total return, but it also increases your chances of reaching your goals.

From years 5-15 we then introduce a mixture of stock and bonds to best capture long-term returns while still not being fully invested in the market.

Then, because the market has never been negative over a 15 year period, we are comfortable investing in 100% equity for goals over 15 years away.

While we’re not saying this is exactly right for everyone, we believe that this simple, repeatable approach can lead to better outcomes. There’s nothing like the stress of a market downturn when you need the money. However, if you utilize liability driven investing, you would know that you don’t need that long-term money right now when it’s currently down 20%. You can afford to let that come back which will hopefully reduce the risk of a panic-induced sale of your portfolio, permanently reducing your returns.

Summary

Utilizing liability driven investing can maximize your chances to reach your goals by helping you align your investments with your plan. By carefully managing the risk in your plan but also knowing when to take risks, you give yourself the highest chances to succeed.

Remember, to have the best liability driven investment framework, you need to know the answer to the following questions:

1. How much money will I need for my goal?
2. When will I need the money for my goal?
3. How much return can I expect over that period?

I hope you found this intro to liability driven investing helpful. If you’re a small business owner and want to learn how liability driven investing can help you, feel free to hit the talk with an advisor button to learn more!

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