What is liability-driven investing?
Liability-driven investing, or LDI, is an investment strategy that focuses on matching assets with current and future liabilities. The approach is used by companies with pension plans to help ensure that liabilities—which consist of current payments to retirees and future payments promised to employees upon their retirement—can be funded by the plan’s assets.
How does LDI differ from a traditional investing strategy?
The funded status of a corporate pension—or defined-benefit (DB)—plan is calculated by subtracting the plan’s liabilities from its assets. Traditional investment strategies for DB plans focus on generating a specific rate of return for the plan’s assets. This rate of return is typically based on a market benchmark or index—with a goal of generating returns in excess of the benchmark.
Liability-driven investing, by contrast, focuses on aligning the plan’s assets with the projected benefit obligations, or liabilities, due to plan participants. There is typically a mismatch between assets and liabilities in defined-benefit plans, due in large part to the impact of interest-rate changes on both. In a standard pension plan, liabilities are typically far more sensitive to rate fluctuations than assets are. This causes a plan’s liabilities to grow or shrink at a much greater rate than its assets as interest rates change. Liability-driven investing aims to eliminate the difference between the two, matching assets with liabilities in order to better manage the plan’s risk of not meeting obligations to employees and pensioners.
A plan’s projected liabilities over a certain length of time—such as 10 years—are usually calculated by an outsourced chief investment officer (OCIO) provider, asset management firm, investment consultant or actuarial firm, as part of a comprehensive study of the plan’s assets and liabilities. Investment policy and asset allocation decisions are then typically made with the overarching goal of meeting these liabilities.
What are the hallmarks of an LDI strategy?
There is no one-size-fits-all approach to an LDI strategy, as the needs of each individual plan sponsor vary based upon funded status, plan status1, institution type and the financial health of the sponsoring organization. However, most LDI strategies aim to satisfy two key objectives:
- Mitigating the risk that a pension plan will not be able to make the payments promised to its employees and pensioners.
- Generating returns from the plan’s assets.
Let’s take a closer look at both.
How does LDI mitigate the risk of unfunded liabilities?
Key risks for pension plan sponsors include changes in interest rates and inflation, as well as duration, which is a measurement of how sensitive a fixed-income instrument’s price is to rate fluctuations. All three of these risks can have sizable impacts on the value of future liabilities.
Falling interest rates, for example, can lead to a significantly greater increase in liabilities than assets, causing the plan’s funding status to drop. The same holds true for inflation, which erodes the value of a plan’s assets. Such drops in funded status are typically bad news for plan sponsors requiring larger, unexpected catch-up contributions if the plan's funding drops below a certain level.
An LDI solutions provider will generally conduct a full-fledged assessment of these risks on behalf of the plan sponsor, ensuring that the downside risks are acceptable and clearly understood. Leading LDI providers will typically then work with the sponsoring organization to establish a liability benchmark for use in determining if the plan’s assets are generating sufficient returns to fulfill its promises to current and future retirees. From there, an overall asset allocation strategy is selected to better manage and mitigate these risks. Often, this includes customizing the duration of the plan’s assets relative to its liabilities by using long-dated bonds and derivatives. An asset and liability modeling tool that can produce multiple simulations is of particular use in this instance, as it allows the plan sponsor to compare the potential impacts that asset allocation alternatives may have on funded status and cash contributions.
How are returns generated in an LDI strategy?
In an LDI approach, a portion of the portfolio is typically built upon liability-hedging strategies to reduce interest-rate risk. These strategies may employ the use of STRIP Bonds2, long government and credit bonds and derivative exposures. Leading LDI solutions providers typically employ hedging strategies that are capital-efficient, and we believe that the best ones also offer dynamic portfolio management in order to exploit market opportunities.
Most liability-driven investing strategies will also involve defining the plan’s non-LDI assets as return-seeking assets, and then implementing an asset allocation designed specifically to close the shortfall in the plan’s funded status. This can include shifting the plan’s return-seeking exposure toward a global equity orientation, including exposure to listed real assets and private equity where appropriate. These asset classes may offer more resilient cashflows, helping assets grow faster than liabilities in volatile markets.
The bottom line: What to look for in an LDI solutions provider
Each organization has its own unique set of challenges and circumstances, which evolve and change over time. This is why we believe it’s vital for liability-driven investing strategies to be flexible by design, allowing for easy customization and adaptability in the face of shifting internal and external factors. Ultimately, we believe that a uniquely tailored LDI solution, bolstered by a flexible implementation platform and broad actuarial and advisory capabilities, is best equipped to create real, lasting value for pension plans.
1 Plan status is based on a pension plan being open to new plan members and managing investments on their behalf or being closed. Examples include open/ongoing, frozen or terminated pension plan.
2 STRIPS are U.S. bonds that are sold at a discount to their face value and pay full face value at their maturity