The core focus of liability-driven investing (LDI) is to reduce risk by hedging interest-sensitive liabilities. As pension risk management strategies have evolved over the last two decades, LDI has taken on a more prominent role for single employer pension plans. Implementation approaches for LDI have become more sophisticated along the way as well. This paper outlines and explores modern approaches to LDI for pension plans, whether the goal is efficiently constructing a very tight liability hedge or tactically implementing a more active strategy to potentially earn outsized returns while hedging.
This paper begins by exploring the interaction between a plan’s projected cash flows and the ever-contorting yield curve to build a foundation for understanding liability risk. Full asset-liability immunization is discussed as a theoretical approach with practical limitations. Next, there is a demonstration of how dollar durations can be used to measure how much interest rate risk is hedged for a given plan (that is, its hedge ratio). By applying those concepts together, a more complete model for evaluating the effectiveness of an LDI strategy is presented, clarifying not just how interest rate risk is being hedged broadly, but also the potential exposure to changes in the shape of the yield curve.
With that framework for analyzing LDI strategies established, the focus of the paper shifts to practical implementation techniques and advanced tactics for active management. First, there’s an illustration of how LDI implementation requires balancing various key objectives. Next, there’s an evaluation of full bond matching approaches versus fund-based approaches, highlighting the advantages associated with each. Then, active strategies are considered for various objectives, including the tactical management of duration weights, credit exposures and yield curve positioning. Finally, the role of LDI is considered in two contrasting end-state solutions for well-funded frozen pension plans: plan termination versus hibernation.