A liability driven investment (LDI), otherwise known as liability driven investing, is primarily slated toward gaining enough assets to cover all liabilities, both present obligations and those that will be accrued in the future. Liability driven investment is also used as a specific term to describe a range of investment approaches that are designed to help schemes reduce the volatility of their funding level by addressing interest rate and inflation risks. LDI can therefore be considered as another tool within the range of investment options that are available to schemes which may be useful depending on the objectives that have been set.
Liability Driven Investment for Individuals
For a retiree, utilizing the LDI strategy starts with an estimation of the amount of income the individual will need for each future year. All potential income, including social security payments, is deducted from the yearly amount that is needed, thus helping to determine the money that will have to be withdrawn from the individual’s retirement portfolio to meet the established income needed annually. The yearly withdrawals then become the liabilities that the LDI strategy must focus on. The retiree’s portfolio must invest in a manner that provides the individual with the necessary cash flows to meet the yearly withdrawals, accounting for intermittent spending, inflation and other incidental expenses that arise throughout the year.
Liability Driven Investment for Pension Funds
A pension fund 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 balance sheet. 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 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.
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