Senior Living Business: The Common Sense Of Liability-Driven Investing--
Evaluate Portfolios In The Context Of Debt And Other Obligations
Not every not-for-profit senior living organization reviews its balance sheet to see how its liabilities and other obligations impact the amount and type of each asset included in the organization’s investment portfolio. Liability-driven investing (LDI) is an approach that involves evaluating investments in the context of debt and other obligations. The concept began in Europe and was initially directed toward pension fund management. It was particularly attractive for that purpose, because pension plans are required to meet an actuarial rate of return to fund future retiree obligations and benefits.
“Pension plans have a very well-defined liability that can be matched through asset allocations or investments,” explained Adam Smith, Investment Strategist at Lancaster Pollard Investment Advisory Group, “but LDI really can be applied to any institution or even any individual. Every institution has liabilities that feed into the LDI framework, which calls for managing assets in the investment portfolio relative to those liabilities rather than simply looking for a specific overall rate of return. LDI simply marries the asset side of the balance sheet with the liability side of the balance sheet. Basically, it’s a common sense approach.”
So LDI changes the focus on assets alone to a focus on both assets and liabilities. Organizations that consider only the asset side may simply seek asset allocations that provide, say, a 10% rate of return, even though the risk at that rate may be too high to cover their liabilities. Instead, those organizations should construct a plan that aligns the risk level with the liabilities and only then look to maximize the return. If the investment manager is unaware of an organization’s liabilities and makes wholesale changes to the portfolio—perhaps taking a number of realized losses that flow through to the income statement—it could trigger a debt covenant violation and lead to technical default.
The LDI approach is especially important for not-for-profit senior living providers, whose assets and investment portfolios are geared toward serving their missions and whose budgets may rely on a specific rate of return from investments. “You want to minimize the volatility of those returns as much as possible,” said Smith.
Understanding risk tolerance
The term “risk tolerance” is familiar, but many people have difficulty defining it, calculating it, and determining it, according to Smith. He defines risk tolerance as the amount of allocation to investments with equity-like volatility vs. the amount of allocation to investments with fixed-income-like volatility. “The more an organization needs to reduce volatility due to its liabilities, the more it should turn to investments with fixed-income-like volatility,” he advised.
To identify risk tolerance through LDI, the initial step is to analyze the organization’s balance sheet and determine its liabilities, e.g., outstanding debt, debt covenants, reliance on an endowment or foundation, reliance on a particular spending policy. Based on that assessment, the organization can set a budget that considers the amount of downside it can handle before tripping a debt covenant and missing the consistent return target.
“Once that’s accomplished,” explained Smith, “the organization can look at the asset side and decide which asset classes offer liquidity, provide options in terms of investment managers, avoid egregious fees, and things of that nature. Then, by creating an asset allocation that minimizes risk as much as possible, the probability of violating covenants or of not achieving the target rate of return is reduced to a comfortable level.”
Of course, trying to protect the organization from unexpected events—such as the financial turmoil of the past 18-24 months—is a huge challenge. But by embracing a more strategic long-term perspective, the organization is better able to handle the ups and downs of market
“One of the biggest risks to an institutional portfolio is trying to pick when to get in and out of the market,” said Smith. “Our research shows that missing the best couple of months in which to invest can have significant negative impact on returns over a period of 30-40 years. So we advise our clients to get the strategic long-term asset allocation right in order to handle and actually benefit from market volatility.”
Typically, the bounces off the bottom of the market are so violent that investors miss out on the recovery if they’re not consistently invested in the market. History has proven that it’s extremely difficult, if not impossible, to time the market accurately—and consistently, which is the bigger issue. It’s important, therefore, to make sure that the organization’s strategic asset allocation is appropriate for the long term—“and then have the discipline to stick to it,” emphasizes Smith.
As plan objectives and risk tolerance change—if liabilities change, for example, and the organization takes on more debt or the endowment or foundation income that is supporting the institution becomes a bigger part of the budget—then the asset allocation policy will have to be adjusted. But again, that must be a strategic decision and not a knee-jerk reaction to the market suddenly going down 20%, as it did in the first quarter last year.
The biggest risks when evaluating investments are liquidity and valuation, according to Smith. “Liquidity risk is something that many institutions overlook,” he says, “If you have to change your asset allocation policy and you have a significant allocation to illiquid investments, you can’t really sell out of those. You have to sell out of your liquid investments. You need to be able to sell the investments you want to sell, rather than just the investments that you can sell, when you want to sell them.”
Valuation risk plays out in asset classes such as private equity, real estate, or hedge funds, where a valuation is based on illiquid assets and could be written down because of the stress on the market. That flows through to the institution’s balance sheet, its income statement, and suddenly the days cash on hand or debt service coverage target is negatively impacted.
“Investors can also overlook volatility risk,” Smith added. “People often see certain asset classes in a vacuum and don’t appreciate the volatility that a particular subset of the asset class might bring to the portfolio.” For example, people who believe that bonds have lower volatility and are a safer investment may decide to add those to the portfolio. But there’s a big difference between investment-grade bonds and high-yield bonds. “We would argue that you should have exposure to high-yield bonds,” said Smith, “but investors need to understand that those tend to have more equity-like volatility. So they must be clear about the higher risk that high-yield bonds present and have different expectations for how they should perform.”
A hedge fund, which has been a popular way for investment advisors to diversify portfolios in recent years, is simply a vehicle to hold assets that can apply to different investment strategies. One hedge fund manager may apply a very conservative fixed-income strategy while another could run a very highly leveraged growth equity and risky market strategy. The issues with all hedge funds, however, are that they’re very opaque, hard to value, offer less liquidity, and typically have high fees. People have learned about those issues from recent experience and are now becoming more vigilant about investing in hedge funds. “We would argue that other liquid asset classes —such as commodities, REITs, TIPS, high-yield bonds, and so forth—offer lower correlations, better diversification, and less risk than hedge funds,” said Smith.
While LDI is basically a risk-management framework, it does not require the removal of all risk from the investment plan. The amount of corporate bonds and derivatives in the plan, for example, will determine how much interest-rate risk can be tolerated.
Buying into LDI
In essence, LDI is a strategy that’s better instituted sooner rather than later. Some 51% of U.S. corporate and public pension funds already used an LDI strategy in 2009, up from 36% in 2008 and 17% in 2007, according to an SEI Institutional Solutions survey. The single biggest roadblock to adopting LDI is a lack of education about and technical understanding of the LDI approach, according to a survey by Pensions & Investments, an industry newspaper.
Many senior living providers have been open to implementing LDI, because it’s an intuitive approach that makes sense. It creates a well-defined plan, a very detailed investment policy statement that clearly lays out an efficient asset allocation strategy, itemizes the organization’s liabilities, addresses appropriate responses to changes on either side of the balance sheet, and determines how often the policy should be reviewed.
“LDI is very much policy-driven,” added Smith, “and it provides cover for the board in its fiduciary responsibility. Rather than a committee of seven sitting around a table and deciding to update the asset allocation if the market fluctuates, selling all the equities if the market collapses (as it did last spring), or having a hasty reaction when debt comes onto the balance sheet, LDI provides discipline and strategic thinking. It limits the possibility of damaging spontaneous reactions.”
It’s also important to set up triggers so portfolio managers can implement strategic investment changes, whether those benchmarks are liability-focused or asset class-specific in terms of the investments that the organization actually holds.
The most obvious liability benchmarks for senior living providers are the debt covenants that they don’t want to violate, along with the targeted rate of return that they’re trying to outperform. Or they might try to outperform an inflation-specific target—inflation in general or perhaps an inflation measurement that’s specific to their particular business.
On the asset side, a blended benchmark that equates to the asset allocation policy is useful. For example, a senior living institution with 70% in equity-like investments and 30% in fixed-income-like investments in terms of volatility would use a blended benchmark that’s 70/30.
By and large, organizations in all industries are becoming more interested in LDI and are open to accepting that approach, regardless of whether the organization is for-profit or not-for-profit. People saw what happened over the past 18-24 months. Some are still scared about what happened, and many still have questions about how to proceed. LDI helps them develop strategic thinking, a long-term asset allocation plan, and the discipline to handle whatever the market throws their way.
“Although LDI applies to all types of organizations,” said Smith, “they may be interested for different reasons. The framework they’d utilize would be very similar from one to another, but the implementation and portfolios would be very different—because their liabilities are so very different.”