Since then, oscillating investment markets, declining funding levels and other factors have brought home the need to structure investments so that performance relative to liabilities is the primary measure of investment success. Enter liability-driven investments (LDIs). Rather than a complete novelty, LDIs are part of the long-standing quest to improve the suitability of pension fund investments to achieve surplus coverage of pension payments. Various routes, from pure immunization to active surplus risk-baring, can be taken.

Pure immunization tries to establish a liability-matching portfolio aiming to avoid financial risk in the pension trust by combining assets that ideally exhibit the same sensitivities to interest rates, inflation and other variables as the liabilities themselves, so that liability cash flows are exactly covered by asset cash flows. Full immunization against surplus risk reflects the attitude of a strongly risk-averse investor and is the extreme expression of an LDI concept. A broader understanding emphasizes the explicit liability orientation of the investment portfolio, allowing for some controlled surplus risk exposure in order to potentially earn the corresponding risk premium.

The Active LDI approach addresses the challenge to enhance asset performance relative to liabilities, and with such positive surplus-returns help to reduce contributions and to hedge against uncertainties in long-term liabilities. This requires inclusion of asset classes that are expected to earn a risk premium for their surplus risk they add relative to liabilities, such as stocks or hedge funds. In line with their risk preference, investors will choose a (static) strategic asset allocation (SAA), which may rely either on an investment portfolio characterized by moderate risks relative to liabilities (liability-balanced portfolio) or on a more aggressive set of investments comprising higher risks and higher return expectations (a liability-opportunity portfolio). Active portfolio mandates seek to achieve an additional, uncorrelated return contribution that further enhances relative outperformance.

THE ACTIVE DYNAMIC LDI approach embraces an even wider dimension. In line with recent accounting and regulatory requirements, portfolios promising a higher return in the long run are permissible only to the extent that short-term risks can be controlled, funding level does not fall below a certain level or regulatory stress tests are met. Based on the available risk budget (one hinging on a predefined funding level), asset allocation in dynamic LDI strategies is carefully adjusted over time.

A case in point is risklab’s Dynamic Surplus Return Management (DSRM) LDI strategy, which is a concept to dynamically hedge liability risks by holding a portfolio whose character matches available surplus risk budgets. When risk budgets increase, the strategy is re-arranged to efficiently employ higher risk budgets and aim for return opportunities by holding a portfolio whose characteristics match the liability opportunity portfolio. Adjustments towards a liability defensive portfolio with only a small amount of tracking error relative to liabilities are made when risk budgets shrink. A DSRM-LDI Strategy typically includes both pro-cyclic and anti-cyclic elements to tune the return advantages of an aggressive strategic asset allocation with the risk advantages of a liability-matching strategy.

A RISK-EFFICIENT LDI STRATEGY shifts asset allocation dynamically in line with the available risk budget along a surplus-efficient frontier characterizing those portfolio allocations that earn the highest (systematic) risk premiums to compensate for the assumed surplus risk. Different surplus-efficient portfolios protect against negative market movements relative to liabilities and help resolve the conflict between long-term pension investment goals and short-term (regulatory) risk requirements. The optimal LDI strategy is selected based on the fund’s individual goals and key figures used to manage the business. Possible risks include funding-level deterioration, excessive additional contributions or violation of regulatory requirements. On the return side the fund endeavors to maximize investment returns to improve safety buffers and benefits to its members.

CHOOSING THE DSRM-LDI STRATEGY over a static liability matching solution can reduce pension plan funding costs. Higher surplus return expectations go along with additional mismatch and underfunding risks. The advantage of a dynamic LDI strategy lies in its active approach to monitoring risks to try to keep them within acceptable limits. Dynamic LDIs fit well into established structures using subfund set-ups for active portfolio management combined with a dynamic risk overlay component. Strategic positioning along the efficient frontier is frequently implemented with the help of several active and/or passive subfunds using fixed-income, equity or alternatives mandates that employ different, diversified asset return sources. Dynamic risk management operates within a separate overlay fund that does not conflict with subfund management. Overall, LDI solutions of this type can generate a client specific pension investment profile that satisfies the need for a close and transparent linkage between assets and liabilities.