What is Liability Driven Investing?
Many large companies and institutions engage in a type of investing known as liability driven investing. The purpose of this type of investing isn’t to generate income. It’s purpose is to cover future expenses. Companies that offer pensions, for example, have future obligations to pay out an annual amount. To meet that obligation, they develop specialized strategies that ensure investment revenues meet or exceed total expenses.
The more future liabilities, the more complex a liability driven investing plan becomes. Often, companies with pensions find themselves managing these strategies in the billions of dollars. Such a high figure calls for a strategic approach.
A Simplified Liability Driven Investing Examples
Say, for example, a company has $10 million in annual pension liabilities. Instead of paying them out from its revenues, it’ll develop a liability driven investing strategy. The company will fund an investment portfolio designed to generate at least $10 million in annual returns. When the time comes to pay out to the pension, the company will rely on its portfolio gains.
Individual investors can also develop these plans. If a person wants to retire with an income of $100,000 annually, they may purchase bonds that generate $15,000 in coupon payments annually. They can do this if the combination of social security and 401(k) distributions only pay out $85,000 per year.
The Modern Approach to Liability Driven Investing
The goal of liability driven investing is to cover future expenses. To do that, however, investments need to generate adequate returns. But at the same time, they also need to mitigate risk. As any investor knows, risk and reward operate opposite each other. Therefore, it’s important to maximize both without sacrificing either. This can be done if investors and advisors turn to a dual portfolio strategy.
The modern approach to liability driven investing involves two separate portfolios. It involves an aggressive portfolio and a defensive portfolio. By separating these objectives, investors can focus on one strategy per portfolio. And they can do this without compromising the overall investment goal.
Performance Seeking Portfolios (PSPs)
Aggressive liability driven investing portfolios are Performance Seeking Portfolios. As the name implies, the portfolios welcome a higher level of risk as a way to capitalize on strong asset performance. These portfolios are market-beating. They typically represent investment vehicles like growth stocks and emerging market funds. They’re not reckless in pursuit of profit, but they do risk volatility.
Liability Hedging Portfolios (LHPs)
Defensive liability driven investing portfolios are Liability Hedging Portfolios. In general, the purpose of these portfolios is to safeguard against volatility by investing in stable, safer assets. These portfolios contain bonds and blue-chip dividend stocks, among other stable investments. They’re meant to offset losses incurred by PSPs. Moreover, they’re also meant to provide consistent, reliable returns that fund a significant portion of the liability driven investing plan’s future obligations.
Together, PSPs and LHPs balance the potential for high investment returns with the fear of falling victim to market volatility. How companies choose to balance these portfolios depends on future expense obligations.
Why Liability Driven Investing is so Important
This strategy is very important as companies grow larger and commit more expenses to the future. It becomes imperative for long-term financial stability. Without one, the company risks financial insecurity. Or worse, it can risk insolvency that results in defaulting on future obligations.
An example of the importance of an effective strategy comes from General Electric (NYSE: GE). In 2017, GE was obligated to make pension payments to 243,000 retirees and beneficiaries. The company’s investment strategy was insufficient to generate the funds required to satisfy these obligations. As a result, GE slashed its long-time dividend. This caused a massive sell-off of the company’s stock. In turn, causing the price to drop further. Then, in 2019, GE froze its pension program for 20,000 employees.
GE is a cautionary tale of how future expenses can quickly cripple a company’s balance sheet without some way to anticipate and account for them. Liability driven investing is the solution most companies turn to.
Liability Driven Investing for Individual Investors
Many retail investors engage in this type of investing as they enter retirement. For example, the maximum amount Social Security will pay out is $3,148 a month (2021). Meanwhile, Required Minimum Distributions (RMDs) vary depending on your age and amount. Therefore, individuals who want or need to live beyond this need to adopt this strategy to generate fixed income.
Bonds are the most common mode of liability driven investing. Coupon payments serve to generate income. Annuities are another example, as are dividend-paying stocks. However, most individual investors only need to adopt an LHP to fund their strategy. They’ll already benefit from supplemental income generated by qualified retirement funds and Social Security.
The Balance Between Greed and Fear
There’s a big difference between conventional investing and liability driven investing. In the former, the goal is to accumulate wealth. In the latter, the goal is to cover future costs you know you’ll collect. Overall, this changes the investing dynamic significantly. It’s not about investing for profit. It’s about investing to prevent debt. With that in mind, these plans are typically more strategic.
And as an investor, it’s important to have an understanding of these investing practices. In fact, it can help you build wealth through smart investments. To learn more, sign up for the Liberty Through Wealth e-letter below! You’ll receive tips and tricks from leading market experts.
The nature of liability driven investing makes it important to focus on both portfolio profitability and risk mitigation. Unfortunately, it’s impossible to do this in a single portfolio without controversy. Therefore, the dual portfolio strategy of modern investments strikes an important balance between greed and fear. One that gives companies and individuals the results they need to cover future debts. The key in any liability driven investing strategy is peace of mind; with the knowledge that future expenses won’t become future debts.