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What is liability-driven investment?

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What is liability-driven investment?

Liability-driven investing (LDI) refers to a type of investment strategy that seeks to accumulate enough assets to pay current and potential liabilities.

Before we go through what liability-driven investment means, we first need to understand defined benefit pension plans, as LDI is most commonly used by pension schemes.

A defined benefit pension plan is an employer-sponsored retirement or pension for employees that factors in multiple variables – such as the length of employment or salary history – to determine the benefit that retirees will receive.

Employers are responsible for overseeing the plan’s investments and risk, and usually hire a third-party investment manager to help carry out these responsibilities.

Defined benefit pension plans or schemes guarantee their members a monthly income – known as a liability when they retire. Pension scheme providers must ensure they have enough assets, such as bonds, stocks, or other instruments that can generate returns, to cover the promise to pay pensioners income over the life of the scheme.

In order to fulfil these responsibilities, asset managers use LDI solutions. LDI matches assets and liabilities using derivatives to reduce or even eliminate the risk of insufficient fund to pay scheme members.

A company or individual’s investment strategy based on the cash flows required to cover potential liabilities in the future is, essentially, the definition of liability-driven investment.

Key Points

  • LDI acquires assets, such as bonds, stocks or derivatives to ensure a firm has sufficient cash to pay existing and future liabilities.

  • LDI is popular for defined benefit pension plans, which guarantee a monthly pay-out for its holders when they retire.

  • As providers of defined benefit pension plans must pay their current obligations and secure funds for future pay out, they use LDI to minimise the risk of not having sufficient funds to pay the monthly income for members.

Understanding LDI: Balancing funding level and risks

A pension scheme’s funding level can be used to determine whether it is able to meet its commitment to pay income to its members. It determines the total number of liabilities covered by the scheme.

Pension fund providers must secure investment returns or contributions to maintain or grow their funding position, which can shift over time as the value of liabilities changes. 

Funding positions have become more volatile as a result of future payment values being frequently correlated with three highly uncertain and volatile factors: interest rates, inflation and the members’ duration on the scheme.

The lower interest rates mean higher current value of liabilities. The present value of liabilities would also be higher when the inflation expectations were higher. Higher life expectancy also increases the current value of the liabilities.

Therefore, pension funds or individuals will seek investments that link to those factors. 
According to BNY Mellon’s Introduction to Liability-Driven Investment

“If the value of scheme assets and liabilities react to these factors in the same way, funding level volatility can be greatly reduced. This focus on reducing funding level volatility lies at the heart of LDI.”

This explains why LDI was an increasingly popular investment product offered by asset managers to pension funds.

According to the Investment Association’s 2021 to 2022 investment survey, LDI strategies grew to almost £1.6trn from the £400bn reported in 2011.

Liability-driven investment explained: basic principles

So, how does a liability-driven investment work to balance risks and improve funding level?

LDI separates an investment strategy into two parts: one that controls liability risks and the other that produces suitable investment returns. If a pension fund can achieve both, the volatility of its funding level will be reduced, and its assets will grow faster than its liabilities.

The LDI strategy invests a portion of the pension plan’s assets to monitor the sensitivity of its liabilities to interest rates and inflation in order to reduce risks. 

Accordingly, asset and liability values increase or decrease together when interest rates or inflation expectations change, and the funding level of the pension plan should be less erratic.

The remainder of the pension plan or a person’s assets are invested to produce income or growth. A pension fund typically has a specific return target determined by a variety of diversified asset classes that corresponds to their deficit size and risk tolerance.

Liability-driven investment examples

A pension fund can use liability-driven investing to buy securities, such as bonds, that offer annual interest rate payments of at least the same amount when it needs to cover a funding deficit of $100,000.

If a pension firm wants to generate a 7% return on its assets, investing in an equity that achieves the desired returns would be the most practical course of action. This is another illustration of how to use LDI to generate growth.

Pension funds can choose LDI exposure on their portfolio by adjusting the hedge ratio. The hedge ratio determines the extent to which the funding level is protected against inflation risks or interest rate risks.

Hedge ratios for interest rate risks, for example, are calculated by comparing the sensitivity of a firm’s assets to movements in interest rates relative to the sensitivity of their liabilities to these same movements.

The bottom line

Liability-driven investment can provide a pension scheme with various strategies to ensure they are able meet their commitment to their members. It can also provide protection against inflation and interest rate risks

However, remember that your decision to trade or invest, as well as your investment strategy, should depend on your risk tolerance, expertise in the market, portfolio size and goals. Always remember to do your own research before investing in an asset. And never trade money that you cannot afford to lose.

FAQs

What type of investors use liability-driven investment?

Liability-driven investment (LDI) is typically used by defined benefit pension plans – employer-sponsored pension programmes that guarantee monthly incomes for their members.

Why is LDI preferred by defined benefit pension plans?

Defined benefit pension plans need to ensure that their assets can yield returns sufficient to cover existing payouts and the value of future payments, which typically stretch out for decades, depending on the life expectancy of their members. LDI can help pension schemes to choose an investment strategy that can also cover liabilities in the future by investing to manage risks and generate growth at the same time.

What are the factors that can affect the ability of a pension fund to meet its commitment?

Interest rates, inflation, and the longevity or life expectancy of the members can all affect a pension fund’s ability to meet its commitments. Lower interest rates result in increased liabilities' current values. When inflation expectations are higher, the present value of liabilities would also be higher. Longer life expectancies will also raise the liabilities' current value.

 

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