What Is a Liability-Driven Investment?
A liability-driven investment (LDI) is an investment in assets that can generate the cash to pay for financial obligations (liabilities).
This type of investing is common with defined-benefit pension plans because companies and pension funds are obligated to provide the guaranteed income promised to the beneficiaries. With the largest pensionplans, liabilities frequently climb to billions of dollars.
Key Takeaways
- A liability-driven investment provides cash needed to meet financial obligations (liabilities).
- Liability-driven investments are common for defined-benefit pension plans and insurance companies that guarantee payouts, now and in the future.
- Liability-driven investing involves managing the risks of interest rate fluctuations and market volatility.
- The disadvantage of LDIs is that they offer lower returns compared to riskier investments such as equities.
- Individuals and companies can both put liability-driven investing strategies to use.
Understanding Liability-Driven Investments
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.
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:
- Government bonds
- Inflation-linked bonds
- Corporate bonds
- Derivatives for hedging purposes
- Real estate
- Infrastructure projects
Liability-Driven Investing for Individual Investors
For a retiree, a liability-driven investmentstrategy starts withestimatingthe amount of income they'll need for each future year. All potential income, including Social Security benefits, is deducted from the yearly amount that the retiree needs. Any shortfall equals what the retiree will have to withdrawfrom their retirement portfolio annually.
The yearly withdrawals then become the liabilities that the LDIstrategy 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.
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.
Liability-Driven Investingfor Institutional Investors
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 pensioners. And, the strategy must include ways to minimize risk.
Some strategies that involve mitigating risk and capturing greater returns could include:
Cash Flow Matching
Duration Matching
Duration matching involves building a portfolio of assets with a duration that aligns with the duration of the liabilities. 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 ininterest rates.
Immunization
Immunization
Immunization takes another approach to duration matching, with the same goal of mitigating the effect of a change in interest rates on the value of a portfolio and on an investor's liabilities.
Risk Reduction
Interest Rate Hedges
Interest rate hedging involves the use of financial instruments such as financial futures orinterest rate swaps to safeguard the value of a portfolio from the effect of interest rate movements.
For example, an interest rate swap can exchange a fixed interest rate for a floating rate (or vice versa) to reduce a portfolio's exposure to changes ininterest rates.
Inflation Hedges
To counteract the value-eroding effect of inflation, a portfolio can include investments such as inflation-linked bonds, real estate, and infrastructure. These are assets that can perform well during periods of increasing inflation and protect portfolio returns.
Higher Returns
Debt Investments
By including in a portfolio fixed-income securities such as corporate bonds and other debt securities that have a higher risk than Treasuries, investors may be able to capture higher yields.
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 LDI Strategies
If an investor needs an additional $10,000 in income beyond what Social Security payments provide, they can implement anLDIstrategy by purchasing bonds that will provide at least $10,000 in annual interest payments.
Alternately, an investor can use an LDI approach that splits investment into two buckets; one, a fixed-income investment for consistent returns and the other, a higher risk equity investment. The greater returns offered by equities could be moved into the fixed income allocation over time.
How Did Liability-Driven Investing Start?
It 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 LDIs?
In addition to pension funds, other investors that use them 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?
They 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 an LDI 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 potential interfere with with goal, if their risk is too great.
The Bottom Line
A liability-driven investment is an investment that can ensure that financial obligations can be met. Liability-driven investing involves matching assets, which produce cash flow, to the liabilities requiring cash.
While individual investors can put LDI investing to good use, a pension fund with billions of dollars of liabilities is a perfect example of the type of investor that most often employs it.
