Liability-Driven Investment (LDI), also known as investing with a focus on obligations aims at accumulating enough assets to pay for all short-term and future liabilities or obligations. For example, this could be a defined-benefit plan where retirement benefit or payout is guaranteed. An employer can choose between a benefit that is fixed or variable. The plan is normally funded by a regular contribution from the employer into a tax-deferred account, often a proportion of the employee’s wage.
This regular contribution made by the employer is further invested in a pool of financial instruments (this may include or be limited to fixed-income instruments, equity instruments, currencies, commodity derivatives as well as other alternative investment assets) to generate the necessary funds required to pay off the future benefit liabilities promised to the employees.
The foregoing scenario describes a liability-driven investment. This approach to investment can be used to finance long-term projects where such would have its initial execution at a future date.
Liability-driven investment strategies often use the approach of initially managing and reducing liability risk, and afterward providing asset returns.
Efficient and effective management of pensionable assets must be the primary consideration for every pension fund or pension plan that applies the LDI method. More specifically, the focus should be on the assurances made to pensioners as well as other third parties whom they are obliged to. These guarantees turn into the liabilities that the plan must aim towards.
This method immediately contrasts with the investment strategy that focuses on the asset side of the balance sheet of a pension fund. There is not a single accepted method or definition for the particular steps conducted in relation to LDIs. Managers of pension funds frequently employ a range of techniques under the LDI strategy umbrella.
However, they often have two goals and the first is to control or reduce liability risk. These risks, which have a direct impact on the pension plan’s financing condition, range from a change in interest rates to currency inflation. In order to achieve this, the company may forecast present obligations into the future in order to arrive at an appropriate estimate of obligation after taking into consideration inflation and order factors. Hence, to produce returns from the resources already at hand, the pension company may look to invest in debt and trade equity/variable instruments on margin to augment its return from its fixed-income instrument in order to fulfil its future pensionable obligation that offers returns comparable to its expected obligations.
There are key techniques often used in a liability-driven investment strategy, one of which is hedging. In order to prevent or restrict the fund’s exposure to inflation and interest rate risks, hedging is frequently used, either wholly or in part. This is because these risks frequently have a negative impact on the fund’s ability to fulfil its obligations to its members.
Bonds were frequently utilised in the past to partially hedge interest-rate risks, but the LDI strategy tends to place more emphasis on employing swaps and other derivatives.
Whatever strategy is employed, it usually follows a path that tries to gradually minimise risks, like interest rates, and obtain returns that are equal to or greater than the rise of expected pension plan liabilities.