Liability-driven investment strategy

Liability-driven investment (LDI) is an asset–liability management approach that designs the asset portfolio around the size, timing, and risk profile of known obligations. It is used by defined benefit pension schemes and insurers to reduce funding volatility and to help ensure cash is available when benefits fall due.

LDI techniques include cash-flow matching and duration matching. Schemes may also use interest rate and inflation swaps, gilt repos, and other derivatives to hedge sensitivity to market moves.

In personal retirement planning the approach first sets aside assets for essential spending. Investors then add return-seeking assets for discretionary goals, often using bond ladders or annuities to match near-term cash flows, with the remainder taking market risk to grow future income.

Defined benefit schemes use LDI to align asset behaviour with the present value of promised benefits. Portfolios hold gilts and investment-grade credit, plus overlays such as interest rate and inflation swaps, to hedge discount-rate and inflation risk. The focus is on stabilising the funding ratio rather than maximising absolute return.

Schemes choose a liability benchmark that reflects how they value obligations. The benchmark may reference gilt yields or swap curves. Inflation-linked liabilities are often hedged with index-linked gilts and inflation swaps. The discount rate under IAS 19 is based on high-quality corporate bond yields. Under US GAAP Statement No. 158 sponsors recognise the funded status on the balance sheet.

Managers measure asset and liability sensitivity to rates and inflation. Many schemes target a hedge ratio based on PV01 (the change in value for a one basis point move) or key rate duration (sensitivity at selected maturities). Duration matching reduces the effect of small rate moves on the funded status. Schemes use curve and key-rate hedges when sensitivity varies by maturity. Overlays allow hedging while keeping cash for expenses and collateral.

Most strategies include a return portfolio to close deficits and build surplus. Trustees often adopt journey plans that reduce growth exposure as funding improves. This is sometimes called de-risking or a glide path. The mix depends on covenant strength, time horizon, and risk appetite.

Schemes implement LDI through segregated mandates or pooled LDI funds. Pooled funds give smaller schemes access to hedging and operational support. Segregated mandates allow more tailoring of curve hedges and collateral processes. Reviews after 2022 discuss how pooled structures, rebalancing, and collateral movement affected outcomes in stress. Trustees are expected to document collateral waterfalls and run regular tests of resilience.