LDI for Individual Portfolios

Abstract

Liability-driven investing (LDI) represents a fundamental improvement over asset-only portfolio optimization techniques because it incorporates the risk characteristics of the liability when solving for the optimal portfolio. Well-meaning practitioners have begun embracing LDI techniques when building portfolios for individual investors without properly considering the unique characteristics of the individual’s liability or the risk attributes of the assets retirees have available to fund the liability. These oversights result in highly conservative portfolios like those used by institutional investors. Individuals have greater flexibility in retirement spending, in part because retirement expenses aren’t a legal liability, and generally have other assets or resources that can be used to fund retirement expenses in addition to the ability to continue working during retirement. After incorporating the unique risks associated with the retirement liability, as well as the asset retirees commonly have to fund retirement, we find that retirees are likely best served with portfolios that are balanced and more diversified than traditional LDI models suggest.

TOPICS: Portfolio theory, portfolio construction