Building a decumulation investment strategy for clients
- Be able to describe a “liability relative” approach to investing.
- Identify the different implementation approaches to liability-relative investing.
- List the “hybrid strategies” which incorporate annuities and/or insurance into a portfolio.
- Be able to describe a “liability relative” approach to investing.
- Identify the different implementation approaches to liability-relative investing.
- List the “hybrid strategies” which incorporate annuities and/or insurance into a portfolio.
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.
Model portfolios are a popular way of creating and managing a consistent asset allocation for a given risk profile.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.
Implementation approaches
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.
