What is a ‘Liability Driven Investment – LDI’
A liability driven investment (LDI), otherwise known as liability driven investing, is primarily slated toward gaining enough assets to cover all liabilities, both present obligations and those that will be accrued in the future. 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.
BREAKING DOWN ‘Liability Driven Investment – 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 can be utilized by a variety of clients.
Liability Driven Investment (LDI) for Individual Clients
For a retiree, utilizing the liability driven (LDI) strategy starts with an estimation of 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benefits, is deducted from the yearly amount that is needed, thus helping to determine the money that will have to be withdrawn from the individual’s retirement portfolio to meet the established income needed annually. The yearly withdrawals then become the liabilities that the liability driven investment (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.
For example: if an investor needs an additional $10,000 in income, beyond income that social security payments provide, a liability driven investment (LDI) strategy can be implemented by purchasing bonds that will provide at least $10,000 in annual interest payments.
Liability Driven Investment (LDI) for Pension Funds
For a pension fund or pension plan that utilizes the liability driven investment (LDI) strategy, the focus must be placed on the pension fund’s assets, more specifically on the assurances made to pensioners and employees. These assurances, or promises, 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 in regard to the specific actions taken in regard to the liability driven investment (LDI) approach; managers of pension funds quite often utilize a variety of approaches under the liability driven investment (LDI) strategy banner. There are a number of key tactics that seem to repeat under this strategy, however. Hedging is often typically 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 to achieve returns that either match or exceed the growth of anticipated pension plan liabilities.