What Is a Liability-Driven Investment?

A liability-driven investment (LDI) is an investment in assets that can generate the cash to pay for financial obligations (liabilities).

This type of investing is common with 澳洲幸运5官方开奖结果体彩网:defined-benefit pension plans because companies and pension funds are obligated to provide the guaranteed income promised to the 澳洲幸运5官方开奖结果体彩网:beneficiaries. With the largest pension plans, liabilities frequently climb to billions of dollars.

Understanding Liability-Driven Investments

The goal of investing in LDIs is to make sure that an investor with long-term financial commitments such as a pension fund or 澳洲幸运5官方开奖结果体彩网:insurance company has the income-generating assets it needs to satisfy its financial obligations (e.g., payout🅘s to plan participants and customers making claims).

Thus liability-driven investing focuses on matching the cash flow generated by assets to the cash flow required by liabilities and then minimizing risks that could affect returns, such as those associated with interest rate fluctuations and market volatility. Hedging strategies involving 澳洲幸运5官方开奖结果体彩网:derivatives can be used to help reduce this risk.

Because the objective of these portfolios is to generate income and mitigate risk, the returns typically are ▨lower than those offered by portfolios with a more aggressive, higher-risk approach to investing.

Investment professionals who construct liability-driven investment portfolios must examine their firm's or client's liabilities, propose the right 澳洲幸运5官方开奖结果体彩网:asset allocation, select the appropriate investments, and monitor the 澳洲幸运5官方开奖结果体彩网:portfolios carefully, beiꦬng sure to make changesꦉ when necessary.

Types of Liability-Driven Investments

These investments must be able to provide the income required by the liabilities as well as potential protection against 澳洲幸运5官方开奖结果体彩网:interest rate risk, market volatility, and the risk posed by 澳洲幸运5官方开奖结果体彩网:inflation. Types of liability-driven investments include:

• Government bonds
• Inflation-linked bonds
• 澳洲幸运5官方开奖结果体彩网:Corporate bonds
• Derivatives for hedging purposes
• 澳洲幸运5官方开奖结果体彩网:Real estate
• 澳洲幸运5官方开奖结果体彩网:Infrastructure projects

Liability-Driven𓆉 Investing for Individual Investors

For a retiree, a liability-driven investment strategy starts with estimating the amount of income they'll need for each future year. All potential income, including 澳洲幸运5官方开奖结果体彩网:Social Security, is deducted from the yearly amount that the retire🃏e needs. Any shortfall equal🌳s what the retiree will have to withdraw from their retirement portfolio annually.

Theཧ yearly withdrawals then become the liabilities that the LDI strategy must focus on. The retiree must invest in a manner that provides the necessary cash flow, accounting for extra or unexpected spending, inflation, and other incidental expenses that may arise.

Liability🦩-Driven Investing for Institutional Investors

For an institution such as a pension fund or pension plan, the focus must be placed on investments that generate enough cash flow to satisfy liabi🦩lities, which are the payments guaranteed to retirees. The strategy must also include ways to minimize risk.

Some strateg𒁃ies that involve mitigating▨ risk and capturing greater returns include the following.

Duration Matching

Duration matching involves building a portfolio of assets with a duration that aligns with the duration of the liabilities. If interest rates move in a direction that hu🌄rts the value of the assets, that can be mitigated by the effect on the liabilities. Duration matching thus can help reduce the sensitivity of the portfolio's value to changes in interest rates.

Immunization

Immunization takes 澳洲幸运5官方开奖结果体彩网:another approach to duration matching,☂ with the same goa🍨l of mitigating the effect of a change in interest rates on the value of a portfolio and on an investor's liabilities.

Interest Rate Hedges

Interest rate hedging involves the use of financial instruments such as financial futures or 澳洲幸运5官方开奖结果体彩网:interest rate swaps to safeguard the value of a portfolio from the effect of interest rate movements.

For example, an interest rate swap can exchange a fixed interest rate for a floating rate (or vice versa) to reduce a portfolio's exposure to changes in 澳洲幸运5官方开奖结果体彩网:interest rates.

Inflation Hedges

To counteract the value-eroding effect of inflation, a portfolio can include investments such as inflation-linked bonds, real estate, and infrastructure. ﷺThese are assets that can perform well during periods of increasing inflation and protect portfolio returns.

Debt Investments

By including fixed-income securities such as corporate bonds and other debt securities that have a higher risk than Treasuries, investors may be able to capture higher yields.

Examples of L✨iability-Driven Investing Stra♛tegies

If an investor needs an additional $10,000 in annual income beyond what Social Security benefits provide, t🌠hey can implement an LDI strategy by purchasing bonds that will provide at least $10,000 in annual interest payments.

Alternately, an investor can use a liability-driven investing appro𓄧ach that splits inve𓆉stment into two buckets; one, a fixed-income investment for consistent returns and the other, a higher risk equity investment. The greater returns offered by equities could be moved into the fixed income allocation over time.

The Bottom Line

A liability-driven investment is an investment that can ensure that financial obligations 🍬can be met. Liability-driven invest♐ing involves matching assets, which produce cash flow, to the liabilities requiring cash.

Both pension f꧂unds and individual investors can put liability-driven investing to good use.🍬