Liability relative investing means an investment strategy that considers, not only the asset allocation, but also the shape and term of future withdrawals that an investment strategy is designed to support.
Where future liabilities (e.g. retirement income from defined benefit schemes) are contractual and defined in advance, the approach is known as liability-driven investing.
Where future liabilities (e.g. retirement income from Sipps, or other goal-based savings) are non-contractual and not defined in advance, the approach is known as liability-relative investing.
The investment strategy is not to generate performance for performance’s sake but to ensure that the market value of an investment portfolio matches, and continues to match, the present value of future expected liabilities - the expected withdrawal profile of a retirement plan.
A positive mismatch can be considered a 'surplus', a negative mismatch can be considered a 'deficit' or 'shortfall'.
As liability-relative investing is considering how to match present values of assets now to liability streams in the future, the key determinants of a strategy’s success in matching those liabilities are:
- The amount of expected withdrawals - as expressed by a withdrawal rate.
- When those withdrawals will start - retirement or target date.
- The time horizon over which those withdrawals are made - investment term.
- The discount rate (interest rate) applied to those expected withdrawals over time to calculate present values in real terms, adjusting for inflation.
Managing liability-relative investment strategies is, therefore, not only about considering risk and return. It’s about considering risk, return, interest rates (duration), inflation and time horizon relative to withdrawal profile of each individual client’s decumulation plan.
While liability-relative investment is broadly practised in the institutional market, it is less developed in the retail market.
We summarise some of the different approaches to liability-relative and retirement investing taken below.
Bucket approach: Pioneered a by US financial planner Harold Evensky of Evensky & Katz, the bucket approach seems simple.
It divides a portfolio into three buckets: a near-cash bucket for 'now', a cautious portfolio for 'soon' and a balanced portfolio for 'later'.
The advantages of the bucket approach are 1) it’s easy to visualise; 2) it’s easy to explain; and 3) conceptually matching risk allocation to time horizons makes sense for decumulation.
The disadvantages of the bucket approach are 1) it requires not only the management of each bucket, but also the switching of capital from bucket to bucket, incurring transaction and frictional costs; 2) it requires a very disciplined approach to switch capital across buckets in all market conditions: many advisers/managers risk falling into behavioural traps as they try to time the markets as to when to switch from higher risk to lower risk assets to keep all buckets topped up; 3) the overall asset allocation (as ultimately three buckets is mere presentation, when combined there is only one overall asset allocation) is not being managed in aggregate, meaning it’s harder to control the overall risk profile of the investment strategy.
The bucket approach is best suited for advisers who do not want to use a discretionary fund manager (DFM), and are comfortable managing investment risk themselves and can stay on top of bucket switches consistently across all clients.