Foundations of liability-driven investing

Liability-driven investing, or LDI, has become a focal point for many defined benefit pension plans. Its popularity is due to its effectiveness in helping to reduce interest rate risk. LDI is primarily a de-risking tool for plan sponsors who wish to reduce funded status volatility. This is accomplished by investing in assets that move in tandem with the plan’s liability. Reducing interest rate risk can also reduce the volatility of other pension results like funding requirements, accounting expenses or ultimate settlement costs. As LDI has grown in use and evolved, so have the ideas and vocabulary surrounding it. This paper attempts to demystify these ideas by defining and explaining the core concepts of LDI. 

For a more in-depth review of LDI, please see our paper Next Generation Liability Driven Investing (LDI). For a broader understanding of how pension investment strategies can be customized for a specific plan, please reference our white paper, An Investor’s Guide to Pensions. 

As the name suggests, liability-driven investing (LDI) is an investment style focused on a liability. In simple terms, it’s an investment technique that uses assets to hedge a liability. It’s frequently used by single-employer defined benefit pension plans because their liabilities are very sensitive to interest rates. By hedging interest rate risk, LDI may reduce the volatility of a pension plan’s funded status. When LDI is implemented, a hedge that attempts to partially or fully immunize the plan sponsor from risks associated with interest rates is constructed. LDI is possible because a pension plan’s liability has a quantifiable risk profile. Building an asset portfolio that has the same risk profile creates a liability hedge. This is LDI.

This paper discusses the following:

• What is LDI?
• Basic LDI terminology: projected cash flows, yield curve, etc.
• Types of pension liabilities and interest rates
• Implementation basics
• Implementation approaches: Fully Custom LDI vs Fund Based LDI