Liability-driven investment policies and

asset management Asset management is a systematic approach to the governance and realization of value from the things that a group or entity is responsible for, over their whole life cycles. It may apply both to tangible assets (physical objects such as buildings ...

decisions are those largely determined by the sum of current and future liabilities attached to the investor, be it a household or an institution. As it purports to associate constantly both sides of the

balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...

in the investment process, it has been called a "

holistic Holism () is the idea that various systems (e.g. physical, biological, social) should be viewed as wholes, not merely as a collection of parts. The term "holism" was coined by Jan Smuts in his 1926 book ''Holism and Evolution''."holism, n." OED Onl ...

" investment methodology. In essence, the liability-driven investment strategy (LDI) is an

investment strategy In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics an ...

of a company or individual based on the cash flows needed to fund future liabilities. It is sometimes referred to as a " dedicated portfolio" strategy. It differs from a “benchmark-driven” strategy, which is based on achieving better returns than an external

index Index (or its plural form indices) may refer to: Arts, entertainment, and media Fictional entities * Index (''A Certain Magical Index''), a character in the light novel series ''A Certain Magical Index'' * The Index, an item on a Halo megastru ...

such as the S&P 500 or a combination of indices that invest in the same types of asset classes. LDI is designed for situations where future liabilities can be predicted with some degree of accuracy. For individuals, the classic example would be the stream of withdrawals from a retirement portfolio that a retiree will make to pay living expenses from the date of retirement to the date of death. For companies, the classic example would be a

pension fund A pension fund, also known as a superannuation fund in some countries, is any plan, fund, or scheme which provides retirement income. Pension funds typically have large amounts of money to invest and are the major investors in listed and priva ...

that must make future payouts to pensioners over their expected lifetimes (see below).

LDI for individuals

A retiree following an LDI strategy begins by estimating the income needed each year in the future. Social security payments and any other income is subtracted from the income needed to determine how much will have to be withdrawn each year from the money in the retirement portfolio to meet the income need. These withdrawals become the liabilities that the investment strategy targets. The portfolio must be invested so as to provide the cash flows that match the withdrawals each year, after factoring in adjustments for inflation, irregular spending (such as an ocean cruise every other year), and so on. Individual bonds provide the ability to match the cash flows needed, which is why the term "

cash flow matching Cash flow matching is a process of hedging in which a company or other entity matches its cash outflows (i.e., financial obligations) with its cash inflows over a given time horizon. It is a subset of immunization strategies in finance. Cash flow ...

" is sometimes used to describe this strategy. Because the bonds are dedicated to providing the cash flows, the term " dedicated portfolio" or “asset dedication” is sometimes used to describe the strategy.

LDI for pension funds

following an LDI strategy focuses on the pension-fund assets in the context of the promises made to employees and pensioners ( liabilities). This is in contrast to an approach which focuses purely on the asset side of the pension fund

. There is no single accepted definition or approach to LDI and different managers apply different approaches. Typical LDI strategies involve hedging, in whole or in part, the fund's exposure to changes in

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...

s and

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

. These risks can eat into a pension scheme's ability to keep their promises to members. Historically, bonds were used as a partial hedge for these interest rate risks but the recent growth in LDI has focused on using swaps and other

derivatives The derivative of a function is the rate of change of the function's output relative to its input value. Derivative may also refer to: In mathematics and economics * Brzozowski derivative in the theory of formal languages * Formal derivative, an ...

.
LDI 2.0, aiCIO Magazine, March 2011 Various approaches will pursue a "glide path", which, over time, seeks to reduce interest rate and other risks while achieving a return that matches or exceeds the growth in projected pension plan liabilities.Lemke and Lins, ''ERISA for Money Managers'' §2:64 (Thomson West, 2013). These various approaches offer significant additional flexibility and capital efficiency compared to bonds, but also raise issues of added complexity, especially when the rebalancing of an LDI portfolio following changes in interest rates is considered.
LDI 3.0, aiCIO Magazine, March 2011 LDI investment strategies have come to prominence in the UK as a result of changes in the regulatory and accounting framework. IAS 19 (one of the

International Financial Reporting Standards International Financial Reporting Standards, commonly called IFRS, are accounting standards issued by the IFRS Foundation and the International Accounting Standards Board (IASB). They constitute a standardised way of describing the company's f ...

) requires that UK companies post the funding position of a

on the corporate sponsor's

. In the US the introduction of FAS 158 (

Financial Accounting Standards Board The Financial Accounting Standards Board (FASB) is a private standard-setting body whose primary purpose is to establish and improve Generally Accepted Accounting Principles (GAAP) within the United States in the public's interest. The Securi ...

) has created a similar requirement.

References

Bibliography

* Michael Ashton,
Maximizing Personal Surplus: Liability-Driven Investment for Individuals
, October 28, 2010
Published
in "Retirement Security in the New Economy: Paradigm Shifts, New Approaches, and Holistic Strategies", Society of Actuaries, 2011. * Vincent Bazi & M. Nicolas J. Firzli, “1st annual

World Pensions & Investments Forum The World Pensions & Investments Forum is a research and policy oriented conference organised by the World Pensions Council (WPC), also known as the International Association of Pension Funds (IAPF), in partnership with regional and supranational ...

”, Revue Analyse Financière, Q2 2011, pp. 7–8 * George Coats, ‘Dutch regulator blamed for pensions losses’, Financial News, Dec 14 2010 * Roy Hoevenaars, “Strategic Asset Allocation and Asset Liability Management”, University of Maastricht, 18 Jan. 2008 * Thomas P. Lemke and Gerald T. Lins, ''ERISA for Money Managers'' (Thomson West, 2013). {{Finance Actuarial science Liability (financial accounting) Pensions Investment management

LDI for individuals

LDI for pension funds

See also

References

Bibliography