# Liability-Driven Investment (LDI): What It Is and Examples of Strategies

![Liability-Driven Investment (LDI)](https://www.investopedia.com/thmb/mn5v-EQn-2tRN-Q1yMU8YvZFgM4=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/ldi.asp-final-0a7e5f3b91e14fafa1f40dda4c233f0d.png)

*— Investopedia / Laura Porter*

> **Definition**
>
> A liability-driven investment (LDI) is an investment strategy focused on generating cash flow from assets to meet specific obligations, commonly used by pension funds and insurance companies.

## 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](https://www.investopedia.com/terms/l/liability.asp)).

This type of investing is common with [defined-benefit](https://www.investopedia.com/terms/d/definedbenefitpensionplan.asp) pension plans because companies and pension funds are obligated to provide the guaranteed income promised to the [beneficiaries](https://www.investopedia.com/terms/b/beneficiary.asp). With the largest pension plans, liabilities frequently climb to billions of dollars.

### Key Takeaways

*   A liability-driven investment provides the cash needed to meet financial obligations (liabilities).
*   Liability-driven investments are common for defined-benefit pension plans and insurance companies that guarantee payouts, now and in the future.
*   Liability-driven investing involves managing the risks of interest rate fluctuations and market volatility.
*   The disadvantage of liability-driven investing is that it offers lower returns compared to riskier investments.

## Understanding Liability-Driven Investments

The 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](https://www.investopedia.com/articles/personal-finance/121914/life-insurance-policies-how-payouts-work.asp) 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](https://www.investopedia.com/terms/i/interest-rate-derivative.asp) can be used to help reduce this risk.

Because the objective of these portfolios is to generate income and mitigate [risk](https://www.investopedia.com/terms/r/risk.asp), 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](https://www.investopedia.com/terms/a/assetallocation.asp), select the appropriate investments, and monitor the [portfolios](https://www.investopedia.com/terms/p/portfolio.asp) carefully, being sure to make changes when necessary.

## Types of Liability-Driven Investments

These investments must be able to provide the income required by the liabilities as well as potential protection against [interest rate risk](https://www.investopedia.com/articles/optioninvestor/08/manage-interest-rate-risk.asp), market volatility, and the risk posed by [inflation](https://www.investopedia.com/terms/i/inflation.asp). Types of liability-driven investments include:

*   Government bonds
*   Inflation-linked bonds
*   [Corporate bonds](https://www.investopedia.com/terms/c/corporatebond.asp)
*   Derivatives for hedging purposes
*   [Real estate](https://www.investopedia.com/terms/r/realestate.asp)
*   [Infrastructure](https://www.investopedia.com/articles/stocks/11/real-estate-infrastructure-asset-allocation.asp) projects

## Liability-Driven Investing for Individual Investors

For 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,](https://www.investopedia.com/terms/s/social-security-benefits.asp) 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.

> **Fast Fact**
>
> 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 Investors

For an institution such as a pension fund or [pension plan](https://www.investopedia.com/terms/p/pensionplan.asp), the focus must be placed on investments that generate enough cash flow to satisfy liabilities, which are the payments guaranteed to retirees. The strategy must also include ways to minimize risk.

Some strategies that involve mitigating risk and capturing greater returns include the following.

### Duration Matching

Duration matching involves building a portfolio of assets with a [duration](https://www.investopedia.com/terms/d/duration.asp) 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.

### Immunization

Immunization takes [another approach](https://www.investopedia.com/articles/investing/022615/portfolio-immunization-vs-cash-flow-matching.asp) 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 Hedges

Interest rate hedging involves the use of financial instruments such as financial futures or [interest rate swaps](https://www.investopedia.com/terms/i/interestrateswap.asp) 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](https://www.investopedia.com/terms/i/interestrate.asp).

### Inflation Hedges

To 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 Investments

By including 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.  

> **Important**
>
> 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 Liability-Driven Investing Strategies

If an investor needs an additional $10,000 in annual income beyond what Social Security benefits 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 a liability-driven investing 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.

## How Did Liability-Driven Investing Start?

Liability-driven investing goes back to the day when defined-benefit pension plans were in abundance and companies had to meet their financial guarantees to the beneficiaries of those plans.

## Who Uses Liability-Driven Investing?

In addition to pension funds, other investors that use liability-driven investing include foundations, endowments, insurance companies, and even individual investors who want to ensure guaranteed income for their retirement and manage investment risk.

## Do Liability-Driven Investment Portfolios Usually Include Equities?

Equities can be included depending on the investor's [tolerance for risk](https://www.investopedia.com/terms/r/risktolerance.asp) but many portfolios don't have them, due to their greater risk. The main goal of liability-driven investing is to match assets to liabilities and manage risk so that income is available to satisfy specific financial obligations. Investments that offer high returns can potentially interfere with with that goal, if their risk is too great.

## The Bottom Line

A liability-driven investment is an investment that can ensure that financial obligations can be met. Liability-driven investing involves matching assets, which produce cash flow, to the liabilities requiring cash.

Both pension funds and individual investors can put liability-driven investing to good use.

> **Article Sources**
>
> 1.  Society of Actuaries. "[Liability-Driven Investment Benchmark Model](https://www.soa.org/globalassets/assets/files/resources/research-report/2019/liability-driven-investment.pdf)."