Institutional Portfolios May Not Be Right for You

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It might be tempting to re-create some of the portfolios of big institutional money managers, but that might not always be the best solution for individual retirees. I'm here with David Blanchett, he is the head of retirement research at Morningstar Investment Management, for more.

David, thanks for joining me.

David Blanchett: Thanks for having me.

Glaser: Let's talk a little bit about liability-driven investing. This is a topic that you've written about, a lot of big money managers, insurers use this. Can you just define the term for us?

Blanchett: LDI is a process where you build a portfolio thinking about the risks of your liability. The liability for pensions is paying the participants in a defined-benefit plan. For an investor, its retirement. The key with LDI is thinking about what are the risks of my goal, and how does that affect my portfolio.

Glaser: In practice, if you were to try to do this at an individual level, what would that look like? Or what are practitioners, how are they putting this into practice?

Blanchett: It's tough. I think the first question to ask yourself is, what risks do I have with my goal, and how can I hedge those away with my portfolio. For example, a common goal among retirees is to have income for life adjusted for inflation. When we think about that, inflation is a key risk of the retirement goal. Potentially adding in inflation-hedging assets could be one way to think about hedging that liability as a part of an LDI approach.

Glaser: But you think that this might not actually be the best idea for all investors. Why is that?

Blanchett: I think that a lot of the frameworks that big investors use in terms of hedging liabilities has been applied to individual investors. People are different in terms of their liability for retirement versus, say, an institution that has to hedge the risk of a defined-benefit plan. A few things--one example is that the liability for individuals who are retirees are soft. You can change your mind. You can say, hey, wait a minute, the markets are down, I'm going to live off less. In contrast, in a defined-benefit plan, they have to make that payment every month, guaranteed for life. There's no room at all there to make a change.

The second is that people have other stuff to fund retirement with. We have things like Social Security benefits or other assets that we can use to fund retirement. And so, the perspective you take in terms of that liability just differs across investors, especially institutional investors or individual investors.

Glaser: What would this mean, for say, an annuity? That would be something that would give you that guaranteed income. How does that play in here?

Blanchett: A big question people have is, let's just assume that I'm going to buy an annuity when I retire. How does that affect my portfolio decision? An annuity is usually a one-time purchase. It's a single liability when you retire. Someone may say, well, you should be very conservative as you move toward that purchase decision because if interest rates move up and down, your portfolio changes, it really affects your lifetime income. I agree with that to a certain extent, but here's the thing: Most of us can take on some risk. Most investors don't have all their money in fixed income. The key really is understanding what is the impact for you as retiree if the markets do go down. I think that there is possibly some benefit to having, for example, long-duration bonds in a portfolio to hedge that risk. But long-duration bonds today aren't very attractive. So understand the overall market conditions along with what happened if things move against you in terms of funding your goal.

Glaser: Big picture, what does mean for building a retirement portfolio? What do you think retirees should be doing now versus maybe the conventional wisdom?

Blanchett: What we see a lot is a lot of big investors suggest you should all of your money in inflation-protected securities when you retire. We don't find that at all. We think that in reality most investors have a huge allocation to an inflation-hedging asset like Social Security already. And so, for most people having a well-diversified portfolio of all types of fixed income and all types of equities actually makes the most sense.

Glaser: Well, David, thank you for sharing your research with us today.

Blanchett: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.