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开奖号码历史查询:defined-benefit pension plans because companies and pension funds are obligated to provide the guaranteed income promised to the 澳洲幸运5开奖号码历史查询: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开奖号码历史查询:insurance company has the income-generating assets it nee𒀰ds to satisfy its financial obligations (e.g., payouts 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开奖号码历史查询: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 agg𝔉ressive, 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开奖号码历史查询:asset allocation, select the appropriate investments, and monitor the 澳洲幸运5开奖号码历史查询:portfolios carefully, being 🌸sure tꦅo make changes 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开奖号码历史查询:interest rate risk, market volatility, and the risk posed by 澳洲幸运5开奖号码历史查询:inflation. Types of liability-driven investments include:

• Government bonds
• Inflation-linked bonds
• 澳洲幸运5开奖号码历史查询:Corporate bonds
• Derivatives for hedging purposes
• 澳洲幸运5开奖号码历史查询:Real estate
• 澳洲幸运5开奖号码历史查询:Infrastructure projects

Liability-Driven Investܫing 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开奖号码历史查询:Social Security, is deducted from the yearly amount tha♌t the retiree needs. Any shortfall equals what the retiree 🌞will have to withdraw from their retirement portfolio annually.

The 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 sp𒅌ending, inflation, and other incidental expenses that may arise.

Liability-Driven Investꦅing fo🐻r Institutional Investors

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

Some strategies that involve m🐠itigating 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 hurts the value of the assets, that can be mitigated by the effe꧒ct 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开奖号码历史查询:another approach to durati🤪on🔜 matching, with the same goal 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开奖号码历史查询: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开奖号码历史查询:interest rates.

Inflation Hedges

To counteract the value-eroding effect of inflation, a portfolio can include investments such as inflation-linked bonds, realꦦ estate, and infrastructure. These are assets that can perform well during periods of increasing inflation and protect ꦏportfolio 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 Liability-Driven Investing Strategies

If an investor needs an additional $10,000 in annual income beyond what Social Security benefits provide, they can implement an LD🐬I strategy by purchasing bonds that will provide at least $10,000 in annual interest payments.

Alternately, an investor can use a liability-driven investing approach that splits investment into two buckets; one, a fixed-income investment for consistent returns and t💜he other, a hiꦏgher 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 i🙈nvestment is an investment that can ensure that financial obligations can be met. Liability-driven investing involves matching assets, which produce cash flow, to the liabilities requiring cash.

Both pension funds and individual investors ca🅠n put liability-driven investi🤡ng to good use.