What Is a Liability-Driven Investment?
A liability-driven investment (LDI) is designed to match financial obligations (liabilities) with appropriate income-generating assets. It’s primarily used by defined-benefit pension plans and insurance companies that guarantee payouts, now and in the future. Common LDIs are government bonds and inflation-linked bonds.
Liability-driven investing involves managing the risks of interest rate fluctuations and market volatility. The disadvantage of liability-driven investing is that it offers lower returns because of the low risk of the securities involved.
Key Takeaways
- Liability-driven investments (LDI) aim to generate income to meet long-term financial obligations, such as pension payouts.
- Common LDI strategies focus on managing risks like interest rate fluctuations and market volatility.
- LDI involves aligning an asset’s cash flow with the liabilities’ cash flow to ensure obligations are met.
- Duration matching, immunization, and hedging are key strategies within liability-driven investing.
- Individual investors can use LDI to ensure stable income in retirement, accounting for inflation and unexpected expenses.
How Do Liability-Driven Investments Work?
The goal of investing in LDIs is to make sure that an investor with long-term financial commitments such as a pension fund or insurance company has the income-generating assets it needs to satisfy its financial obligations (e.g., payouts to plan participants and customers making claims).
Thus liability-driven investing focuses on matching the cash flow generated by assets to the cash flow required by liabilities and then minimizing risks that could affect returns, such as those associated with interest rate fluctuations and market volatility. Hedging strategies involving derivatives can be used to help reduce this risk.
Because the objective of these portfolios is to generate income and mitigate risk, the returns typically are lower than those offered by portfolios with a more aggressive, higher-risk approach to investing.
Investment professionals who construct liability-driven investment portfolios must examine their firm’s or client’s liabilities, propose the right asset allocation, select the appropriate investments, and monitor the portfolios carefully, being sure to make changes when necessary.
Key Types of Liability-Driven Investments
These investments must be able to provide the income required by the liabilities as well as potential protection against interest rate risk, market volatility, and the risk posed by inflation. Types of liability-driven investments include:
How Individual Investors Can Use Liability-Driven Investing
For a retiree, a liability-driven investment strategy starts with estimating the amount of income they’ll need for each future year. All potential income, including Social Security, is deducted from the yearly amount that the retiree needs. Any shortfall equals what the retiree will have to withdraw from their retirement portfolio annually.
The yearly withdrawals then become the liabilities that the LDI strategy must focus on. The retiree must invest in a manner that provides the necessary cash flow, accounting for extra or unexpected spending, inflation, and other incidental expenses that may arise.
Fast Fact
The interest in liability-driven investing took hold with urgency when more common investment strategies failed during the various financial upheavals of the early 2000s.
Institutional Approaches to Liability-Driven Investing
For an institution such as a pension fund or pension plan, the focus must be placed on investments that generate enough cash flow to satisfy liabilities, which are the payments guaranteed to retirees. The strategy must also include ways to minimize risk.
Some strategies to manage risk and achieve better returns include the following:
Duration Matching
Duration matching involves creating a portfolio of assets with a duration that matches the liabilities’ duration.
If interest rates move in a direction that hurts the value of the assets, that can be mitigated by the effect on the liabilities. Duration matching thus can help reduce the sensitivity of the portfolio’s value to changes in interest rates.
Immunization
Immunization is another method, similar to duration matching, that aims to reduce the impact of interest rate changes on a portfolio and the investor’s liabilities.
Interest Rate Hedges
Interest rate hedging involves the use of financial instruments such as financial futures or interest rate swaps to safeguard the value of a portfolio from the effect of interest rate movements.
For instance, an interest rate swap can change a fixed rate to a floating rate (or vice versa) to lower a portfolio’s risk from interest rate changes.
Inflation Hedges
A portfolio can include inflation-linked bonds, real estate, and infrastructure investments to fight inflation’s impact on value. These are assets that can perform well during periods of increasing inflation and protect portfolio returns.
Debt Investments
By adding higher-risk fixed-income securities like corporate bonds, investors can potentially earn higher yields.
Important
The objective of liability-driven investments isn’t necessarily a high return, but rather a return from assets that matches the financial obligations of liabilities.
Examples of Liability-Driven Investing Strategies
If an investor needs an additional $10,000 in annual income beyond what Social Security benefits provide, they can implement an LDI strategy by purchasing bonds that will provide at least $10,000 in annual interest payments.
Alternatively, an investor can divide investments into two categories: fixed-income for stable returns and higher-risk equities. The greater returns offered by equities could be moved into the fixed income allocation over time.
How Did Liability-Driven Investing Start?
Liability-driven investing goes back to the day when defined-benefit pension plans were in abundance and companies had to meet their financial guarantees to the beneficiaries of those plans.
Who Uses Liability-Driven Investing?
In addition to pension funds, other investors that use liability-driven investing include foundations, endowments, insurance companies, and even individual investors who want to ensure guaranteed income for their retirement and manage investment risk.
Do Liability-Driven Investment Portfolios Usually Include Equities?
Equities can be included depending on the investor’s tolerance for risk but many portfolios don’t have them, due to their greater risk. The main goal of liability-driven investing is to match assets to liabilities and manage risk so that income is available to satisfy specific financial obligations. Investments that offer high returns can potentially interfere with with that goal, if their risk is too great.
The Bottom Line
Liability-driven investing (LDI) is a strategy that seeks to match investment cash flows with financial obligations, such as pension payouts. Typical users of LDI are large institutions like defined-benefit pension plans, insurance companies, and endowments due to their significant future payout commitments. Individuals such as retirees can adopt the LDI approach to ensure steady income that covers their living expenses.
The primary goal of LDI is to meet financial obligations. The achievement of high returns isn’t part of the strategy. To reduce an LDI portfolio’s sensitivity to changing interest rates and market conditions, managers use strategies like duration matching and interest rate hedging.