What Is Liability-Driven Investing?

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 status, institution type, and the financial health of the sponsoring organization. However, most LDI strategies aim to satisfy two key objectives:

  • 1.) Mitigating the risk that a pension plan will not be able to make the payments promised to its employees and pensioners.
  • 2.) 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 on two fronts. First, larger, unexpected contributions are required if the plan's funding drops below a certain level. Second, the insurance premiums that are required to be paid to the PBGC (Pension Benefit Guaranty Corporation) have increased significantly in recent years.

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 the funded status and cash contributions.

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Disclosure: These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

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