What is liability-driven investing?

What is liability-driven investing?

A liability-driven investment (LDI) is a type of strategy designed to generate enough income to cover a specific liability or expense in the future.

How does liability-driven investing work?

LDI employs a type of asset allocation strategy to match current and future liabilities – so the goal is not to beat an index or benchmark or enhance the portfolio’s return, but to enhance performance relative to the plan’s liabilities, while reducing market volatility and interest rate risk. If an investor wants their plan to ultimately meet multiple liabilities, they can use a cash flow matching strategy: A portfolio of high-quality zero-coupon or fixed-income bonds is purchased to match the amount and timing of the liabilities.

Examples of liability-driven investing

LDI is commonly used by pension plans (also called defined benefit plans), which must ensure their assets can grow enough to make monthly payouts to employees at retirement.

While LDI is primarily used by institutional investors, it can be utilized by individual investors to help fund retirement expenses or a significant purchase (e.g., a home, car or college tuition bill) in the future.

Types of liability-driven investments

Different types of investments used in LDI include fixed-income instruments, such as government bonds (Treasuries) and corporate bonds of various maturities, as well as derivatives; individual investors might also invest in certificates of deposit (CDs), Treasury bills and money market funds. Some also invest in alternative assets like real estate. The goal of LDI portfolios is to generate income to help meet future liabilities while mitigating negative impact from inflation and interest rate fluctuations.

LDI for individuals vs. institutions

LDI is most commonly used by institutional investors, including pension plans, also known as defined benefit plans. These plans have an obligation to provide retirement income to their members. And for a defined benefit plan to meet its financial commitments, it must grow its assets to match its future liability amounts. Pension liability is predominantly affected by interest rates and inflation. LDI typically uses fixed-income securities and financial derivatives to mitigate the mismatch between defined benefit plan assets and liabilities. Although LDI’s primary goal is to generate income and manage risk, some large pension funds may seek higher returns in riskier alternative assets, such as real estate, private equity, infrastructure, natural resources and hedge funds. The overarching aim is to manage liability risks while maintaining a long-term asset return. As an example, lengthening asset duration (i.e., buying longer-dated bonds guaranteed to pay out a specific coupon each year) can help lessen the impact of falling interest rates.

When it comes to individual investors, the same general method can be used to provide adequate funds for retirement or to help cover a big expense with a preset timeline like college tuition, a home renovation, life insurance premiums or tax bill. Up until 2022, when the U.S. Federal Reserve began its interest rate hiking campaign to battle inflation, rates were ultra-low, and it didn’t pay to park your cash in money market instruments like short-term Treasuries or CDs. You may have been better off keeping your money in cash. Now with rates on six-, nine- and 12-month CDs and short-dated Treasuries reaching 4.5% and higher, individual investors can lock in the income for a future expense.

The key is to know when that bill is coming due – and then match up assets with liabilities. For example, if you know you have to pay $50,000 for a wedding in a year, you can buy a $50,000 CD (at a 5% yield) with a 12-month maturity, and get $2,500 in income at the end of that period. Or someone is planning to do a home renovation in phases, where payments are due at different times, they can, for instance, buy CDs with six-, nine- and 12-month maturities. As those instruments reach their maturity dates, the investor gets the income as needed. The money isn’t subject to the volatility of the equity and bond markets, and you’re getting a decently better yield for that period.

The bottom line

Liability-driven investing is designed to help an investor – whether they are on a pension plan or someone saving for retirement – meet future financial obligations. This type of investing strategy focuses on matching assets, which generate income, to liabilities.

View Disclosures