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Liability Driven Investment

1a. Introduction: Material covered

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1.1          There is growing interest in the concept of liability driven investment (‘LDI’) for many types of institutional investor across many different locations. Liability driven investment is commonly adopted by life insurance companies (although they may not use this term) for liabilities which contain guarantees or underpins, and by defined benefit (‘DB’) pension schemes. Indeed, it can be argued that every institutional investor to some extent bears in mind its liabilities when formulating its investment strategy – few investors have no liabilities at all which they wish to honour!

 

1.2          In these pages we will mainly focus on LDI as applied to DB pension funds (and to a lesser extent insurance companies), although we will also from time to time refer to LDI applied to other types of institution. Large mature DB pension schemes with a greater bond focus typically seem to be more interested in this type of investing than less mature more equity focused clients.

 

1.3          There are several different ways in which a liability driven investment portfolio might be structured. Perhaps the simplest involves two or three parts:

 

(a)    A return seeking portfolio (typically actively managed), invested in those asset classes and vehicles the investor believes have the highest likelihood of outperforming without carrying undue risk.

 

(b)   A protection portfolio involving investment in physical securities, often bonds, chosen in broad terms to have economic characteristics that mimic those of the relevant liabilities. For example, if the liabilities are partly fixed in monetary terms and partly linked to inflation, i.e. to movements in a Consumer Price Index (CPI), then it might incorporate some fixed interest and some inflation-linked bonds.

 

(c)    A swaps overlay (or more generally, a derivatives overlay) portfolio. This would typically consist of one or more swap contracts (or other similar derivatives) that involve the pension fund giving up one set of future cash flows (e.g. ones like those arising from the portfolios in (a) or (b)) and receiving in return another set of future cash flows (e.g. ones more closely matching the relevant liabilities). Precisely how these swaps might be structured can vary. For example, there might be one swap that pays away to the swap counterparty cash flows akin to those arising from the portfolio in (a) or (b) in return for interest payments on some notional principal linked to prevailing cash rates (e.g. LIBOR). There might then be a second swap that paid away this LIBOR cash flow in return for a cash flow that more closely matched the pension fund’s expected liability outgo. Or there might be several swaps on each side that handled different parts of the cash flow (e.g. differentiating by term or by liability type). Or, all of the cash flows might be wrapped up in a single overarching swap.

 

1.4          Usually, investors seek a balance between risk and reward, hence the existence of the return seeking element as per (a). The relative size of the return seeking portfolio versus the protection portfolio/swaps overlay (or to be more precise the relative sizes of the exposures within them) will depend on where within the spectrum of possible alternatives the investor wishes to pitch this balance. Investors may, for example, believe that there is an intrinsic likelihood of long-term outperformance associated with a particular type of asset, e.g. equities (e.g. because a capitalist economy ‘ought’ over the longer term to reward entrepreneurs and hence to reward equity holders more than those who bear less risk of loss from business failure). However, investors may not be willing (or may not be allowed the latitude under regulation) to invest their entire asset base in return seeking assets, even in a diversified portfolio of such assets, because of the risk that the asset performance might be worse than expected. If the investor is subject to mark-to-market regulatory principles (and Kemp (2009) argues that there are good reasons why governments should want most investors to be subject to such rules, if suitably defined, even if this is not always the current position) then ‘performance’ here may not relate merely to the behaviour of the assets between purchase and maturity but also to their market value movements in the meantime. Investors not interested at all in LDI can be viewed as a special case of the above, where their entire portfolio is held in (a).

 


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