The latest concern of many planners, fuelled largely by politicians, is whether people saving for retirement have too much exposure to equities and not enough to bonds.
The evidence is unassailable: over very long periods – say 20–year data points for the past 150 years (US data does exist for this period) – equities have outperformed bonds, cash and property by at least 3 percentage points.
So, if a person is 20 years from retiring and another 20 years from dying, should that person have a big exposure to equities? Perhaps not.
Some professionals operating in a slightly different framework have already been questioning that assumption for the past several years – well before the global financial crisis.
These are the sponsors of defined-benefit pension plans in the UK and US who have moved en masse to liability-driven investment (LDI) strategies. Australian planners should take note of this trend in developing appropriate financial strategies for their clients.
An LDI strategy takes a novel approach to designing an appropriate investment portfolio. It does not try, simply, to make the most money for the least risk for the client given all the relevant factors of age, health and so on.
Instead, an LDI strategy maps out the known and expected cash requirements to cover the legal liabilities of the client, and then puts together a no-risk investment portfolio to ensure they are covered. In this way the fund acts more like an investment banker than a funds manager.
LDI investing is an ultra-conservative way corporations with worker-pension liabilities have limited their downside. The company or plan sponsor has given up on trying to make money out of the market to cover future liabilities. It has, instead, built a portfolio to almost guarantee the bare minimum required.
In today’s corporate world near enough is good enough. The most recent and well-publicised example of this is the US-based FORD pension scheme. It has switched its asset allocation from more than 50 per cent equities to more than 85 per cent bonds for exactly these reasons.
Case study of a European bank 
The pension fund of a large European bank with about $US12 billion in assets and 101,000 employees has phased in an LDI program over the past 10 years. The bank decided that having a traditional pension-plan-investment strategy held too much risk, given that the it had undertaken to pay many workers on a defined-benefit basis.
So, very gradually, the fund moved away from what was roughly the German norm of 50 per cent bonds and 50 per cent equities to an asset allocation of 10 per cent bonds, 70 per cent spread products and 10 per cent equities and alternatives.
The spread products include emerging-market bonds, European corporate bonds, environmental, social and governance (ESG) corporate bonds, US high-yield bonds and long-duration credit ETFs. The 10-per-cent growth asset allocation of equities and alternatives is seen as a total alternatives bet, with no concern for diversification within the equities portion.
Overlayed across the total portfolio are three swaps to further contain risk: credit-default, interest-rate and inflation-linked swaps.
The past 10 years have been unusual and turbulent but the performance since the changes started being implemented in 2002 is worth noting. As of February 2012, the fund had a 10-year annualised-average return of 7.34 per cent, with monthly volatility of 7.12 per cent. Many of PIMCO’s UK LDI clients report a similar experience.
The main point for Australian planners is that a pure LDI strategy will usually include no equities. It can still be quite a sophisticated portfolio with inflation bonds and various hedges in place for its sovereign bonds, high-yield and other debt securities, but no equities exposure.
Components of the LDI philosophy are worth considering in order to inject some rationality and sophistication into the current debate.
It’s actually not about bonds versus shares. It’s about building a portfolio targeting a defined outcome.
Peter Dorrian is head of global wealth management for PIMCO in Australia
