A brief overview of liability driven investing

Liability driven investing (LDI) is a technique that has become very popular for identifying and managing the various risks within defined benefit pension funds.

by Shaun Levitan
Published October 12, 2015

In South Africa, there has been a significant growth in the implementation of these strategies, particularly in the last five years.  The approach and techniques used have wide application and are now being considered in the management of other liability types, for example Defined Contribution (DC) funds.

At its heart, Liability Driven Investing is an approach to investing and involves identifying the liabilities of an investor or institution and then understanding the risks of any investment strategy relative to these liabilities.  At an extreme level, it might involve investing in assets that mitigate all investment risk and tracking the liability closely.  It might also involve deliberately investing in mismatched assets with the intention of outperforming the liability.  The LDI framework provides meaningful information to decision makers so that they appreciate the risks they are assuming.

Shaun Levitan, Executive Director and Co-founder of Colourfield Liability Solutions, clarifies, “Traditionally, LDI has been used for managing the risks of defined benefit pension funds or insurance company obligations, which have liability obligations that they have to meet. The institution’s actuaries or accountants will place a value on this liability (a statutory obligation), which will change due to fluctuating factors like interest rates or inflation, for example. Even if the obligations in rand terms are known in advance, the value placed on these liabilities can be extremely volatile.

“If you take a simple example of a defined benefit pension fund that pays a monthly amount of R10 000 to a pensioner for the rest of their life, the value of the liability determined by the actuary might be R1.2 million.  The value is determined by finding the present value of expected future payments using prevailing interest rates.  It therefore follows that if the appropriate interest rates change, so too does the value placed on the liability. As an extreme example, interest rates might fall by 1% overnight.  The obligation to the pensioner does not change and the pensioner sill expects a monthly pension of R10 000.  However, the value placed by the actuary increases by 10% overnight and now stands at R1.32 million.   A pension fund wishing to mitigate this volatility and achieve investment certainty would use an LDI framework to invest in assets that will change in a similar fashion to match the liabilities and the markets. As the liabilities change, so the assets have to change and this takes out the investment risk.”

Levitan says LDI has a different approach to a benchmark when compared to the traditional investment strategies which might measure performance relative to a real return or industry benchmark. “Here the benchmark is the actual change in the value of the liabilities and the goal is ensuring that the assets and liabilities are closely tracked, despite ongoing market and economic volatility, to mitigate the investment risk.

Levitan argues that these LDI techniques are relevant and appropriate for DC investment strategies.

“Most DC investment strategies focus on maximising the accumulated investments, using benchmarks like inflation plus X per cent, for example, or beating a market index, and the goal is, in essence, the size of the eventual amount of money that can be saved. However, the primary concern of DC members is whether they will have enough income to live off comfortably during their retirement years. Even if an investment does very well against a benchmark, if interest rates fall, it can mean that a client is actually going backwards financially.”

Levitan says the retirement industry should focus on income goals rather than wealth goals. “Liability driven investing facilitates this approach. There is a science to constructing appropriate goals and identifying the liabilities of individual members.  LDI in this context involves determining the optimal combination of equities and risk-free investments that will maximise the likelihood of meeting the income goal.  We might use bonds as part of our risk-free portfolio but we are not bond managers. LDI involves different skills and expertise.”

Levitan says LDI is a dynamic investment approach. “LDI is actually an active investment approach because the liability stream of our clients is changing all the time and so are the prevailing market conditions (including availability and pricing of appropriate financial instruments). Ongoing changes to our LDI portfolio will be required to ensure that our benchmark (the change in value of the liability) is tracked.”

“Another advantage of an LDI framework is that it is possible to show the risks inherent in a particular investment strategy.  In some instances, a risk-free solution also exists and therefore any risk assumed (by not pursuing the risk-free solution) needs to have sufficient expected additional return to compensate for the risk assumed,” he concludes.

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