A short introduction to Liability Driven Investment (LDI) for trustees of defined benefit pension schemes.
What is LDI?
In its broadest sense, LDI is an approach to investment in which all or part of the strategy is designed to match a scheme’s liabilities. Within this context, LDI 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.
What problem is LDI trying to solve?
Scheme funding positions are often volatile and subject to large changes over short periods of time. This can cause significant uncertainty for trustees (in relation to security of benefits) and employers (in relation to contribution levels). Before we consider how to address this volatility, it is important to understand what factors are driving the movements in funding position. This graph illustrates the main risks for a typical scheme, by considering what factors might cause the funding position to worsen based on possible future experience.
The size of the bars illustrates the extent of different risks and illustrates that for a typical scheme, the biggest sources of short term funding level volatility are interest rates as the value placed on the liabilities is very sensitive to changes in long term interest rates. This is because the length of time over which pension benefits are paid is very long and therefore small changes in interest rates can cause a large change in the value placed on benefits. Typically real interest rates are the biggest concern because the majority of liabilities tend to be for inflation-linked benefits.
In recent years, pension schemes have seen this risk play out, with falling gilt yields causing significant deteriorations in funding positions. As a result, schemes are increasingly looking at ways to address this problem.
Schemes can address this risk by investing part of their assets in bonds which have a similar sensitivity to changes in long term interest rates. However, most schemes cannot afford to invest all of their assets in bonds and so a large mismatch between assets and liabilities remains. LDI is an approach that seeks to offer a solution
to this problem.
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