Liability-Driven Investing, Explained

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.

The overall goal in managing the pension portfolio is to reduce risks to the plan over time. Depending upon the demographics of the pension beneficiaries, the advisor might employ a glide path strategy similar to what a target date fund might use as the plan demographics become more skewed toward older participants, if applicable.

Liability-Driven Investing for Individual Clients

Liability-driven investing for individual clients is a bit different than for a pension plan in that there are no requirements that an individual client make a payment to themselves, as with a pension plan that has a stated liability to make those payments. In the case of a private-sector employer, defaulting on pension payments could potentially lead to the company having to declare bankruptcy.

Liability-driven investing for individual clients is most applicable to their retirement income planning. You would look at their sources of income for retirement, including Social Security, a pension if applicable, an annuity and so on. You would compare this with the retirement spending budget needed to allow them to live the retirement they desire.

In determining the “liability equivalent,” you would subtract regular monthly payments such as Social Security and others to come up with a monthly amount that is needed from the client’s retirement accounts like IRAs or 401(k)s, plus taxable investment accounts. Under an LDI approach, this would be the liability that their portfolio is designed to fund.

As with a pension or other type of institutional account, you might need to adjust the asset allocation over time to maintain the right balance between downside risk and potential return.

Factors to consider in working with an individual client in terms of their retirement funding include:

• How risky is the goal your client is trying to achieve? By this, we mean how far along are they toward achieving their retirement income goal. For example, if they have a portfolio that is close to what they are likely to need in terms of the asset level, the portfolio does not have to assume a great deal of risk in order to meet their retirement income needs. On the other hand, if they are closing in on retirement and their portfolio is well short of where it needs to be, then an LDI approach would dictate the need to assume more investing risk or make some adjustments in their retirement income planning.
• How much certainty does the client require with respect to funding their goal? The more certainty required around the client’s goal, the more conservative their investing approach should be.
• What role does the portfolio play in the client’s overall retirement planning? If the client has a sufficient level of income from sources like Social Security and a pension, then they can take a more aggressive investing approach. On the other hand, if their investments are needed to fund the bulk of their retirement, your approach likely will be a bit more conservative.

Liability-driven investing is about formulating an investment approach that matches the assets and the liabilities of the portfolio, along with considerations as to an appropriate level of investment risk. While there may be some differences in the execution, these principles apply whether we are talking about a pension portfolio or your individual client’s retirement portfolio. 

Roger Wohlner is a financial writer with over 20 years of industry experience as a financial advisor.