what is a liability driven investment 
a liability driven investment ldi is an investment in assets that can generate the cash to pay for financial obligations liabilities this type of investing is common with defined benefit pension plans because companies and pension funds are obligated to provide the guaranteed income promised to the beneficiaries with the largest pension plans liabilities frequently climb to billions of dollars understanding liability driven investmentsthe goal of investing in ldis is to make sure that an investor with long term financial commitments such as a pension fund or insurance company has the income generating assets it needs to satisfy its financial obligations e g payouts to plan participants and customers making claims thus liability driven investing focuses on matching the cash flow generated by assets to the cash flow required by liabilities and then minimizing risks that could affect returns such as those associated with interest rate fluctuations and market volatility hedging strategies involving derivatives can be used to help reduce this risk because the objective of these portfolios is to generate income and mitigate risk the returns typically are lower than those offered by portfolios with a more aggressive higher risk approach to investing investment professionals who construct liability driven investment portfolios must examine their firm s or client s liabilities propose the right asset allocation select the appropriate investments and monitor the portfolios carefully being sure to make changes when necessary types of liability driven investmentsthese investments must be able to provide the income required by the liabilities as well as potential protection against interest rate risk market volatility and the risk posed by inflation types of liability driven investments include liability driven investing for individual investorsfor a retiree a liability driven investment strategy starts with estimating the amount of income they ll need for each future year all potential income including social security benefits is deducted from the yearly amount that the retiree needs any shortfall equals what the retiree will have to withdraw from their retirement portfolio annually the yearly withdrawals then become the liabilities that the ldi strategy must focus on the retiree must invest in a manner that provides the necessary cash flow accounting for extra or unexpected spending inflation and other incidental expenses that may arise the interest in liability driven investing took hold with urgency when more common investment strategies failed during the various financial upheavals of the early 2000s liability driven investing for institutional investorsfor an institution such as a pension fund or pension plan the focus must be placed on investments that generate enough cash flow to satisfy liabilities which are the payments guaranteed to pensioners and the strategy must include ways to minimize risk some strategies that involve mitigating risk and capturing greater returns could include duration matchingduration matching involves building a portfolio of assets with a duration that aligns with the duration of the liabilities if interest rates move in a direction that hurts the value of the assets that can be mitigated by the effect on the liabilities duration matching thus can help reduce the sensitivity of the portfolio s value to changes in interest rates immunizationimmunization takes another approach to duration matching with the same goal of mitigating the effect of a change in interest rates on the value of a portfolio and on an investor s liabilities interest rate hedgesinterest rate hedging involves the use of financial instruments such as financial futures or interest rate swaps to safeguard the value of a portfolio from the effect of interest rate movements for example an interest rate swap can exchange a fixed interest rate for a floating rate or vice versa to reduce a portfolio s exposure to changes in interest rates inflation hedgesto counteract the value eroding effect of inflation a portfolio can include investments such as inflation linked bonds real estate and infrastructure these are assets that can perform well during periods of increasing inflation and protect portfolio returns debt investmentsby including in a portfolio fixed income securities such as corporate bonds and other debt securities that have a higher risk than treasuries investors may be able to capture higher yields the objective of liability driven investments isn t necessarily a high return but rather a return from assets that matches the financial obligations of liabilities examples of ldi strategiesif an investor needs an additional 10 000 in income beyond what social security payments provide they can implement an ldi strategy by purchasing bonds that will provide at least 10 000 in annual interest payments alternately an investor can use an ldi approach that splits investment into two buckets one a fixed income investment for consistent returns and the other a higher risk equity investment the greater returns offered by equities could be moved into the fixed income allocation over time 