Liability Driven Investment (LDI)
Candlefocus EditorThe general approach of LDI consists of minimizing and managing liability risks, first and foremost. It involves evaluation of the plan's cash flow needs and maximizing its assets. An investment plan is drawn up such that it will attract portfolio assets that will be able to cover the organization's liabilities.
The second component of an LDI plan is the generation of asset returns. Asset returns are then allocated to the investment plan to provide additional benefits to the defined-benefit plan. To achieve this, LDI plans are designed to acquire different types of assets that have different levels of risk and return.
The risk associated with liabilities is managed by taking into account multiple sources, such as interest rate, inflation, and credit risks. To do this, liabilities are segmented into separate risk categories, such as short-term versus long-term and fixed-to-floating liabilities. These categories are used to customize the portfolio to meet the liabilities, by diversifying and managing risk in the most efficient way.
The asset returns generated by an LDI plan are used to provide additional funds to the organization. Assets are typically selected through an optimization process, which is based on the liabilities of the organization and the expected returns of the portfolio. US Treasuries, corporate bonds and equities are commonly employed in such a strategy.
In order to ensure that the plan meets its goals and objectives, it is essential that the plan manager understands the risks and rewards associated with the investment strategy and conducts extensive due diligence. Additionally, the plan manager should consider the impact of future events, such as market volatility and changes in interest rates and credit risk, on the plan’s portfolio.
Liability Driven Investment is a viable, dynamic and customized approach that is used to assist organizations in meeting their liabilities and generating returns from fixed-income portfolios. By taking into account future liabilities, diversifying assets and utilizing advanced investment strategies, LDI plans can be used to create a robust and reliable portfolios.