What Is a Liability-Driven Investment?

What Is a Liability-Driven Investment?

Let me explain what a liability-driven investment, or LDI, really is. It's an approach where you invest in assets specifically to generate the cash needed to cover your financial obligations, which we call liabilities. You'll see this a lot with defined-benefit pension plans, where companies and funds have to deliver on promised incomes to beneficiaries. For the biggest plans, these liabilities can run into billions of dollars.

Key Takeaways

Here's what you need to know right away: An LDI gives you the cash to handle your liabilities. It's standard for pension plans and insurance firms that promise payouts now and later. You have to manage risks from interest rate changes and market ups and downs. The downside? Expect lower returns than you'd get from riskier investments.

Understanding Liability-Driven Investments

The main point of LDIs is to ensure that if you're running a pension fund or insurance company with long-term commitments, your assets produce the income to meet those payouts to participants or claimants. So, you focus on aligning the cash from assets with what the liabilities demand, and you work to cut down risks like interest rate shifts or market volatility. You might use hedging with derivatives to help with that.

Since the goal is steady income and risk control, these portfolios usually deliver lower returns than aggressive, high-risk ones. As an investment professional, you'd look at the liabilities, suggest asset mixes, pick investments, and keep monitoring and adjusting as needed.

Liability-Driven Investing for Individual Investors

If you're a retiree, start your LDI strategy by figuring out your yearly income needs going forward. Subtract all expected income like Social Security from that. Whatever's left is what you'll pull from your portfolio each year—those become your liabilities. Invest to create that cash flow, factoring in inflation, surprises, and extra costs.

Liability-Driven Investing for Institutional Investors

For a pension fund, you concentrate on investments that produce cash to cover guaranteed retiree payments, while minimizing risks. Strategies include duration matching, where you build a portfolio with asset durations matching liabilities to offset interest rate impacts. Immunization is similar, aiming to shield the portfolio and liabilities from rate changes.

You can use interest rate hedges like futures or swaps to protect against rate movements—for instance, swapping fixed for floating rates. For inflation, include things like inflation-linked bonds, real estate, or infrastructure that hold up when prices rise. Adding higher-risk debt like corporate bonds can boost yields over Treasuries.

Examples of Liability-Driven Investing Strategies

Suppose you need $10,000 more yearly beyond Social Security; buy bonds that pay at least that in interest. Or split into two parts: one for steady fixed-income returns, another for riskier equities, shifting equity gains to fixed income over time.

How Did Liability-Driven Investing Start?

It began back when defined-benefit pensions were common, and companies had to fulfill their guarantees to beneficiaries.

Who Uses Liability-Driven Investing?

Besides pension funds, you'll find foundations, endowments, insurance companies, and individuals seeking secure retirement income and risk management using it.

Do Liability-Driven Investment Portfolios Usually Include Equities?

Equities might be in there if you can handle the risk, but many skip them due to volatility. The focus is matching assets to liabilities and controlling risk for reliable income—high-return investments could disrupt that if they're too risky.

The Bottom Line

An LDI ensures you can meet financial obligations by matching cash-producing assets to liabilities. Both institutions like pension funds and individual investors can benefit from this approach.