Liability-driven Investing: What is it and how does it work?

Liability-driven investing is a paradigm shift in institutional investing as institutions seek to move away from measuring the success of their investment strategies against market benchmarks towards the underlying goal of the portfolio - paying future liabilities.

The concept of asset-liability matching has been around for over half a century. However, the perfect storm of negative equity market performance and falling interest rates from 2000 – 2002, combined to refocus attention of the pension fund community on the concept, through the newly-christened liability-driven investing (LDI). Other factors that have intensified the awareness of LDI are the recent global credit crisis and equity market volatility.

What is Liability-Driven Investing?

Many institutional investors have liabilities to be paid in the future. These include the retirement benefits that pension funds pay and, in the case of insurance companies, disability payments. To meet these future obligations, pension funds, insurance companies and other institutions invest in a mix of shares, bonds and other asset classes with the goal of paying their future liabilities from the returns on these assets. This asset-driven approach means that success is measured by how well the portfolio’s investments perform versus market benchmarks and similar portfolios.

LDI shifts the emphasis of asset allocation back to the real purpose of the assets, which is to meet liabilities rather than to outperform market benchmarks or peer portfolios that have no relation to the institution’s liabilities. Thus, the defining element of a liability-driven investment approach is that portfolio performance is benchmarked against the institution’s liabilities, rather than a benchmark with no direct relation to the liabilities.

Liabilities can be in the form of well-defined commitments - defined benefit funds, for example have a set of rules that govern payments - or members’ expectations to receive a lump sum large enough to provide pension income from a defined contribution fund.

How does Liability-Driven Investing Work?

There are many approaches to LDI and it is important to understand that it is not a product. Conceptually, LDI divides an investment portfolio into two elements: one part hedging the liability risk and a second part looking to generate excess returns. This is why portfolios may take many different forms depending on the institution’s desire for excess returns and risk tolerance.

When creating a liability-driven portfolio the first step is to understand the two characteristics of the liabilities. The first is that liabilities increase when interest rates fall, and decline when rates rise. The second characteristic is that most liabilities are long-term. The longer-term the liabilities, the more sensitive they are to changes in interest rates.

These two attributes make bonds, and in particular long-term bonds, a key ingredient in a liability-driven investment portfolio. This is because bonds typically appreciate when interest rates decline. Also, longer-term bonds are more sensitive to changes in interest rates.

Custom solutions

Apart from the universal use of long-term bonds, liability-driven portfolios vary significantly from institution to institution. This is due to the customised investment strategies of these portfolios. No two institutions have the same liabilities. For example, some institutions have liabilities that are sensitive to inflation and, as a result, may invest in inflation-linked bonds to hedge inflation risk. Other institutions may have a higher tolerance for volatility in the portfolio relative to the liabilities and might employ alternative asset classes, leverage or absolute return strategies in their liability-driven portfolio.