What You Need to Know
- Liability-driven investing attempts to match the portfolio’s investment strategy with future liabilities.
- Liability-driven investing is typically associated with a defined benefit pension, but is becoming more popular with advisors helping individual clients investing for retirement.
- LDI may need to be adjusted periodically based on investment returns, changes in the client’s risk profile and other factors.
Liability-driven investing is an investing methodology that strives to match investment assets with future liabilities. Liability-driven investing, or LDI, is often associated with institutional investment advisors in their efforts to match assets with liabilities for a defined benefit pension plan.
LDI is also gaining popularity with financial advisors to individual clients as a method to help match their retirement assets with their liabilities as part of their retirement income planning for these clients.
Liability-Driven Investing and Pensions
An employer pension plan has a definite set of liabilities based on when the covered employees are expected to retire and commence receiving their benefits. Pension plans go through an actuarial valuation each year that matches the plan’s anticipated liabilities, the pension payments to current and future beneficiaries of the plan, with the plan’s assets.
The outcome of this process produces a funding status for the plan. Pensions must meet certain minimum funding levels. This can vary depending on whether the plan is offered by a public-sector employer or one in the private sector.
The plan’s funding status is a function of investment returns, the level of current and future liabilities, interest rates and employer contributions to the plan. In managing the assets of the plan, an investment advisor will need to take all of these factors into account. Over time, the fund’s asset allocation may change to meet the objective of achieving appropriate plan funding levels.
Besides traditional asset classes such as stocks, bonds and cash, some investment managers may use alternatives as part of the pension portfolio. This could be in the form of hedge funds or private equity instruments, or derivatives to hedge the plan’s interest rate exposure.