Investing lessons from the pension world help us to focus on the critical importance of matching our long-term retirement liabilities with proper long-term investment assets.
Investing Lessons from the Pension World Help Us Generate Better Retirement Expense Estimates
Asset/liability matching originated in the pension world. Pension managers are responsible for meeting specific objectives, namely, paying specific amounts of retirement benefits to a specific number of individuals at specific points in time. To meet their ongoing “liabilities,” these managers must invest their assets carefully to earn the necessary returns, while taking the least risk possible.
As of 2013, liability-driven investing was practiced by more than half of U.S., U.K. and Canadian corporate pension plans, according to research from The Brandes Group. Its use has more than doubled since 2007 ‒ an indication that the 2008 market crash forced many funds to adopt more prudent investment approaches.
Increasingly, asset/liability matching and liability-driven investing are making their way from pensions and other institutions into the world of individual and family investors.
The practices fit neatly into goals-based wealth management. Rather than investing with the simplistic goal of “beating the market,” goals-based investors thoughtfully determine their financial objectives. And then they translate those goals into “liabilities” ‒ such as the future expenses of retirement ‒ with a specific “price tag.”
Rather than just estimating that you might need $3,000,000 for retirement, the asset/liability matching approach looks at how much cash flow you’ll need each year. In your first 10 years, you might require $150,000 per year for normal expenses, plus an additional $50,000 per year for travel. Your expenses in the years following your “travel” years might drop by the reduction in your travel expenses.
Of course you’ll also need to factor in other extraordinary cash needs, like replacing cars and home repairs. And most importantly, you’ll need to account for the typical annual increases in your cost of living ‒ inflation. Failing to account for inflation in estimating your future cash needs can cause catastrophic failure in an asset/liability study and your retirement plan. When inflation averages 3% per year, your expenses end up doubled in 24 years.
Investing Lessons from the Pension World Help Us Build Better Investment Portfolios
With the projected annual future expenses calculated, you can invest more appropriately to help ensure the right amount of money is available when it’s needed.
Liability-driven investing can take more than one form. For instance, you may use multiple investment portfolios, each dedicated to a specific objective. For most investors, however, aggregating goals and corresponding investments into a single portfolio is equally effective and administratively less complex.
Asset/liability matching is superior to the “beat-the-market” approach on a number of levels. First, the approach forces you to plan for your goals, not merely hope for them. This helps ensure that you and your advisors will take the necessary steps to help ensure that the cash will be there when you need it.
Second, it helps you to avoid unnecessary risk. Liability-driven investors invest only aggressively enough to meet each goal: The less risk taken to meet an objective, the better.
Some investors build unnecessarily risky portfolios with the mistaken belief that they need to invest very aggressively to meet their goals, while some savers don’t invest aggressively enough to earn the higher returns needed to meet their goals. Undertaking a study to measure and match your financial needs and investment assets will help you invest to better meet your objectives while taking on appropriate risk.
A pension asset/liability matching framework and goals-based investing are gaining in use among financial advisors working with individual investors. Increasingly, investors understand that beating the market doesn’t mean much in and of itself. What matters most is having the money, when you need it, to fund the goals that are most important to you. If you would like help implementing these techniques in your investment process, we may be able to help.