What Is Liability Driven Investment?
A liability-driven investment, otherwise known as liability-driven investing, is primarily slated toward gaining enough assets to cover all current and future liabilities. This type of investing is common when dealing with defined-benefit pension plans because the liabilities involved quite frequently climb into billions of dollars with the largest of the pension plans.
Understanding Liability Driven Investments (LDI)
The liabilities of defined-benefit pension plans, accrued as the direct result of the guaranteed pensions they are designed to provide upon retirement, are perfectly positioned to benefit from liability-driven investments. However, liability investing is a treatment that a variety of clients can use.
- Liability-driven investments are commonly used in defined-benefit pension plans or other fixed-income plans to cover current and future liabilities through asset acquisitions.
- The general approach to liability-driven investment plans consists of minimizing and managing liability risk followed by generating asset returns.
Liability-Driven Investment for Individual Clients
For a retiree, using the LDI strategy starts with estimating the amount of income the individual will need for each future year. All potential income, including Social Security benefits, is deducted from the yearly amount that the retiree needs, helping determine the amount of money the retiree will have to withdraw from his or her retirement portfolio to meet the established income needed annually.
The yearly withdrawals then become the liabilities that the LDI strategy must focus on. The retiree’s portfolio must invest in a manner that provides the individual with the necessary cash flows to meet the yearly withdrawals, accounting for intermittent spending, inflation, and other incidental expenses that arise throughout the year.
Liability-Driven Investment for Pension Funds
For a pension fund or pension plan that utilizes the LDI strategy, the focus must be placed on the pension fund’s assets. More specifically, the focus should be on the assurances made to pensioners and employees. These assurances become the liabilities the strategy must target. This strategy directly contrasts the investing approach that directs its attention to the asset side of a pension fund’s balance sheet.
There is not one agreed-upon approach or definition for the specific actions taken in regard to the LDI. Pension fund managers quite often use a variety of approaches under the LDI strategy banner. Broadly, however, they have two objectives. The first one is to manage or minimize risk from liabilities. These risks range from a change in interest rates to currency inflation because they have a direct effect on the funding status of the pension plan.
To do this, the firm might project current liabilities into the future in order to determine a suitable figure for risk. The second objective to generate returns from available assets. At this stage, the firm might seek out equity or debt instruments that generate returns commensurate with its estimated liabilities.
There are a number of key tactics that seem to repeat under the LDI strategy.
Hedging is often involved, either in part or in whole, to block or limit the fund’s exposure to inflation and interest rates, as these risks often take a bite out of the fund’s ability to make good on the promises it has made to members.
In the past, bonds were often used to partially hedge for interest-rate risks, but the LDI strategy tends to focus on using swaps and various other derivatives. Whatever approach is used typically pursues a "glide path" that aims to reduce risks—such as interest rates—over time and achieve returns that either match or exceed the growth of anticipated pension plan liabilities.
Examples of LDI Strategies
If an investor needs an additional $10,000 in income beyond what Social Security payments provide, he or she can implement an LDI strategy by purchasing bonds that will provide at least $10,000 in annual interest payments.
As a second example, consider the case of a pension firm that needs to generate 5% returns for the assets in its portfolio. The easiest option for the firm is to invest the funds at its disposal into an equity investment that generates the required returns. Alternately, it can use an LDI approach to estimate split its investment into two buckets.
The first one is a defined-benefit income instrument for consistent returns (as a strategy to minimize liability risk) and the remaining amount goes into an equity instrument to generate returns from assets. Since the goal of an LDI strategy is to cover current and future liability risk, theoretically, it may be possible that the returns generated are moved into the fixed-income bucket over time.