Liability-driven investing (LDI) is a process, more than a pure investment strategy. It means, for an institution or a household, focusing on the liabilities as a starting point for developing its investment strategy. At times, it is referred to as a dedicated-portfolio strategy.
The basic idea is to gain enough assets to cover all current and future liabilities. For example, the primary obligation of a pension fund manager is not to beat a benchmark index, but to ensure that current and future payouts promised to beneficiaries are made.
What Is Liability-Driven Investing?
At an extreme, liability-driven investing may involve establishing a portfolio that closely matches the expected cash flows arising from the liabilities.
In most cases, however, LDI involves establishing a specific liability benchmark and then assessing the risk/reward implications of departures from the liability benchmark to determine the asset mix.
LDI is designed for situations where future liabilities can be predicted with some degree of accuracy.
For individuals, a good example would be the stream of withdrawals (liabilities) from a retirement portfolio that a retiree will make to pay living expenses from the date of retirement to the date of death.
With LDI, a retiree’s portfolio must be invested 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.
For companies, a classic example would be a defined benefit pension fund that must make future payouts to pensioners over their expected lifetimes. The guarantees made to pensioners become the liabilities the LDI strategy must target.
Pension fund managers have two objectives. The first one is to manage/minimize risk from liabilities. These risks could range from a change in interest rates to 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. And then hedge the fund against the risk using various methods – options, swaps and other derivatives.
The second objective for the pension fund manager is to generate returns (cash flow) from the funds’ assets – stocks or bonds – that generate returns commensurate with its estimated liabilities.
What Are the Benefits of Liability-Driven Investing?
The primary advantage of liability-driven investing is that its goal is simply to meet future obligations (liabilities).
It is therefore a more conservative, lower risk (though lower return) portfolio. The primary disadvantage is opportunity cost – a more aggressive portfolio could have possibly made more money.
And whether you’re a pension plan or an individual, implementing LDI is a great way to lower the market volatility component of your retirement/pension plan. This will allow you to more easily plan for your financial future many years or decades down the road.
Liability-driven investing returns significantly exceeded expectations in both 2019 and 2020, returning 14%-17% in 2019, and 12%-15% in 2020, depending on the duration of liabilities.
How to Participate in Liability-Driven Investing
LDI is most often used by ‘frozen’ single-employer pension plans. But it can be used by anyone, by following these basic two steps:
First, consider how different asset allocations interact with the liabilities. The most thorough way to do this is with an asset liability modeling study where an actuary uses sophisticated software to project your liabilities under a variety of scenarios.
You can first model your current asset allocation, while projecting how different scenarios could impact liabilities and funding needs over time. Then you can compare the current allocation to projections of alternate allocations that may better match your liabilities.
Next, choose your investment option lineup. This will be based on the outcome of the asset liability modeling study and the asset allocation that best aligns with your situation.
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The information and data are as March 22, 2022 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
