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A liability-driven investment can be used to minimize risk and cover future liabilities, as well as current ones.

Liability-driven investments are commonly used to minimize risk, as they seek to cover current and future financial obligations. The liability-driven investment (LDI) strategy is often employed by defined benefit plans, which guarantee retirement payouts to those who contribute to the pension. However, individual investors can also use the LDI strategy as an approach to generate asset returns. If you have questions about liability-driven investments or other investing topics, consider working with a financial advisor in your area.

What Is a Liability-Driven Investment

A liability-driven investment is simply any asset held to pay for a current or future obligation. Liability-driven investments provide cash flow to cover liabilities, like how much a retiree needs to withdraw each year from retirement accounts for living expenses.

The LDI strategy diverges from benchmark investing, as the objective isn’t to outperform a market index, like the Dow Jones Industrial Average or S&P 500. Instead, the approach focuses on acquiring assets that will ensure current and future liabilities are met. For example, while the primary goal of a mutual fund manager is maximizing returns, the sole responsibility of a pension fund trustee is ensuring that current and future payouts promised to beneficiaries are made.

LDI Strategies for Individuals vs. Pension Funds

A liability-driven investment can be used to minimize risk and cover future liabilities, as well as current ones.

The LDI strategy isn’t exclusively for large pension plans. Individual investors may adopt the approach to meet specific cashflow needs in retirement. The most important step is calculating one’s liability. If you’re planning for retirement, this will be how much cash you need on an annual basis beyond Social Security benefits and any other potential retirement income. An individual using the LDI strategy will likely compile a bond-heavy portfolio to match their cash flow needs.

A defined benefit pension plan, however, may employ more sophisticated investing strategies, like hedging through options and swaps. Long-term bonds are a common liability-driven investment, but in a low-interest environment more illiquid assets like real estate and infrastructure may also be viable options for pension plans and individual investors, alike.

Disadvantages of Liability-Driven Investments

Opportunity cost is the primary disadvantage of the LDI strategy. Because LDI seeks to mitigate risk, returns on these types of portfolios are typically much lower than portfolios that are more heavily invested in equities. By investing in long-term bonds or other assets with less risk than stocks, an investor forgoes the potential rewards that accompany equities. However, an LDI investor is more interested in meeting their liabilities than the higher returns that riskier assets may bring.

Bottom Line

A liability-driven investment can be used to minimize risk and cover future liabilities, as well as current ones.

A liability-driven investment seeks to cover current and future liabilities, like the payouts guaranteed by a pension fund or annual cash withdrawals from retirement accounts. The LDI strategy is most commonly used by defined benefit plans, like pension funds, whose liabilities may reach into the billions.

Tips for Investing

  • Do you want to start investing but are unsure where to begin? Consider talking to a financial advisor about how they can help you meet your money goals. SmartAsset’s free matching tool can pair you with up to three financial advisors in your area in just five minutes. If you’re ready to be matched, get started now.
  • If you’re not interested in liability-driven investments, consider using SmartAsset’s asset allocation calculator to see how your investments should be divided between stocks, bonds, and other securities.

Photo credit: ©iStock.com/kupicoo, ©iStock.com/Patrick Chu, ©iStock.com/AscentXmedia

Patrick Villanova Patrick Villanova is a writer for SmartAsset, covering a variety of personal finance topics, including retirement and investing. Before joining SmartAsset, Patrick worked as an editor at The Jersey Journal. His work has also appeared on NJ.com and in The Star-Ledger. Patrick is a graduate of the University of New Hampshire, where he studied English and developed his love of writing. In his free time, he enjoys hiking, trying out new recipes in the kitchen and watching his beloved New York sports teams. A New Jersey native, he currently lives in Jersey City.
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