Liability-driven investment strategy
Encyclopedia
Liability-driven is a financial
and actuarial term used to describe investment policies, and, more generally, asset management decisions, that are determined in large part by the sum of current and future liabilities attached to the investment-making entity, be it a household or an institutional investor. As it purports to associate constantly both sides of the balance sheet
in the investment process, it has been called by some a ‘holistic’ investment methodology.
In essence, the liability-driven investment strategy (LDI) is an investment strategy
of a company or individual based on the cash flows needed to fund future liabilities. It is sometimes referred to as a "dedicated portfolio
" strategy. It differs from a “benchmark-driven” strategy, which is based on achieving better returns than an external index
such as the S&P 500 or a combination of indices that invest in the same types of asset classes. LDI is designed for situations where future liabilities can be predicted with some degree of accuracy. For individuals, the classic example would be the stream of withdrawals from a retirement portfolio that a retiree will make to pay living expenses from the date of retirement to the date of death. For companies, the classic example would be a pension fund
that must make future payouts to pensioners over their expected lifetimes (see below).
" or “asset dedication” is sometimes used to describe the strategy.
following an LDI strategy focuses on the pension-fund assets in the context of the promises made to employees and pensioners (liabilities). This is in contrast to an approach which focuses purely on the asset side of the pension fund balance sheet
. Typical LDI strategies involve hedging
, in whole or in part, the fund's exposure to changes in interest rate
s and inflation
. These risks can eat into a pension scheme's ability to keep their promises to members. Historically, bonds
were used as a partial hedge for these interest rate risks but the recent growth in LDI has focused on using swaps
and other derivatives
. These offer significant additional flexibility and capital efficiency compared to bonds, but also raise issues of added complexity, especially when the rebalancing of an LDI portfolio following changes in interest rates is considered.
LDI investment strategies have come to prominence in the UK as a result of changes in the regulatory and accounting framework. IFRS19 (International Financial Reporting Standards
) requires that UK companies post the funding position of a pension fund
on the corporate sponsor's balance sheet
. In the US the introduction of FAS158 (Financial Accounting Standards Board
) has created a similar requirement.
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and actuarial term used to describe investment policies, and, more generally, asset management decisions, that are determined in large part by the sum of current and future liabilities attached to the investment-making entity, be it a household or an institutional investor. As it purports to associate constantly both sides of the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
in the investment process, it has been called by some a ‘holistic’ investment methodology.
In essence, the liability-driven investment strategy (LDI) is an investment strategy
Investment strategy
In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio...
of a company or individual based on the cash flows needed to fund future liabilities. It is sometimes referred to as a "dedicated portfolio
Dedicated Portfolio Theory
Dedicated Portfolio Theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows...
" strategy. It differs from a “benchmark-driven” strategy, which is based on achieving better returns than an external index
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
such as the S&P 500 or a combination of indices that invest in the same types of asset classes. LDI is designed for situations where future liabilities can be predicted with some degree of accuracy. For individuals, the classic example would be the stream of withdrawals from a retirement portfolio that a retiree will make to pay living expenses from the date of retirement to the date of death. For companies, the classic example would be a pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
that must make future payouts to pensioners over their expected lifetimes (see below).
LDI for Individuals
A retiree following an LDI strategy begins by estimating the income needed each year in the future. Social security payments and any other income is subtracted from the income needed to determine how much will have to be withdrawn each year from the money in the retirement portfolio to meet the income need. These withdrawals become the liabilities that the investment strategy targets. The portfolio must be invested so as to provide the cash flows that match the withdrawals each year, after factoring in adjustments for inflation, irregular spending (such as an ocean cruise every other year), etc. Individual bonds provide the ability to match the cash flows needed, which is why the term "cash flow matching" is sometimes used to describe this strategy. Because the bonds are dedicated to providing the cash flows, the term "dedicated portfolioDedicated Portfolio Theory
Dedicated Portfolio Theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows...
" or “asset dedication” is sometimes used to describe the strategy.
LDI in Pension Funds
A pension fundPension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
following an LDI strategy focuses on the pension-fund assets in the context of the promises made to employees and pensioners (liabilities). This is in contrast to an approach which focuses purely on the asset side of the pension fund balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
. Typical LDI strategies involve hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
, in whole or in part, the fund's exposure to changes in interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s and inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. These risks can eat into a pension scheme's ability to keep their promises to members. Historically, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
were used as a partial hedge for these interest rate risks but the recent growth in LDI has focused on using swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
and other derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
. These offer significant additional flexibility and capital efficiency compared to bonds, but also raise issues of added complexity, especially when the rebalancing of an LDI portfolio following changes in interest rates is considered.
LDI investment strategies have come to prominence in the UK as a result of changes in the regulatory and accounting framework. IFRS19 (International Financial Reporting Standards
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
) requires that UK companies post the funding position of a pension fund
Pension fund
A pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
on the corporate sponsor's balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
. In the US the introduction of FAS158 (Financial Accounting Standards Board
Financial Accounting Standards Board
The Financial Accounting Standards Board is a private, not-for-profit organization whose primary purpose is to develop generally accepted accounting principles within the United States in the public's interest...
) has created a similar requirement.