Liability-driven investment strategy

Liability-driven investment strategy

The liability driven investment strategy (LDI) is an investment strategy of a company based on its risk tolerance, the company's ethics and the target return. The target return is usually linked to an index or combination of indices of the sector or any other like S&P 500. This is called the benchmark-driven investment strategy.

Especially in the long-term investments, like pension fund, the benchmark-driven is no longer appreciated. Now the buzzword is liability driven investment LDI. The investment target of the fund is no longer linked to any external index, but to the liability of the fund, which is evaluated by the actuaries. In case of pension fund, it will be the present value of the benefits payable to the employees and pensioners, attached with a probability of those payments made.

LDI in Pension Funds

A pension fund following an LDI focuses on the pension-fund assets in the context of the promises made to employees and pensioners (known as liabilities). This is in contrast to an approach which focuses purely on the asset side of the pension fund balance sheet. Typical LDI strategies involve hedging, in whole or in part, the fund's exposure to changes in interest rates and inflation. 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. These offer significant additional flexibility and capital efficiency compared to bonds.

LDI investment strategies have come to prominence in the UK as a result of changes in the regulatory and accounting framework. IFRS17 (International Financial Reporting Standards) requires that UK companies post the funding position of a pension fund on the corporate sponsor's balance sheet. In the US the introduction of FAS158 (Financial Accounting Standards Board) has created a similar requirement.

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