Liability-Driven Investing Basics
The point is simple: if you owe money in the future (pension benefits, insurance claims, annuity payments), your investment strategy should focus on meeting those obligations rather than maximizing returns. This approach - liability-driven investing, or LDI - sounds obvious until you see what happens when it goes wrong.
What LDI Actually Means
Traditional investing asks: "How do I grow assets?" LDI asks a different question: "How do I ensure my assets cover my liabilities when payments come due?"
The core mechanism: Match the duration and cash flows of your assets to the timing and amount of your liabilities. If you owe $10 million in 2040, you want assets that will be worth approximately $10 million in 2040 regardless of what interest rates do between now and then.
Why this matters: interest rate changes affect both sides of the balance sheet. When rates fall, bond prices rise (good for assets) but the present value of future liabilities also rises (bad for funding status). LDI structures both sides to move together - rates up or down, the gap between assets and liabilities stays stable (Leibowitz and Bova, 2018).
The Duration Matching Principle
Duration measures how sensitive a bond's price is to rate changes. A bond with 8-year duration drops approximately 8% when rates rise 100 bps. The durable lesson: if your liabilities have 15-year duration, your assets should too.
Setup: A pension fund owes $100 million in benefits with weighted average duration of 12 years.
Calculation: Liability present value moves 12% for every 100 bps rate change. To hedge, the asset portfolio needs:
- Duration: 12 years (matching liabilities)
- Dollar duration: $12 million per 100 bps (matching liability sensitivity)
Interpretation: When rates rise 100 bps, liabilities fall $12 million in present value. Assets fall the same amount. Funding gap unchanged. This is immunization - protecting the surplus from rate moves.
Leverage in LDI (Where Problems Start)
Most pension funds don't have enough assets to fully fund liabilities at matching duration. A fund with $80 million in assets and $100 million in liabilities (80% funded) faces a choice:
Option A: Hold $80 million in 12-year bonds. Duration matches, but asset value is $20 million short of liabilities.
Option B: Use derivatives (interest rate swaps, futures) to gain duration exposure without owning the full notional value of bonds. This creates leverage - the fund's effective duration exposure exceeds its actual assets.
Before 2022, UK pension funds relied heavily on Option B. Approximately 60% of UK defined benefit schemes used LDI strategies, and leverage allowed them to match long liability durations while holding some assets in return-seeking investments (Chicago Fed, 2023).
The 2022 UK Crisis: LDI Stress Test
September 2022 delivered a real-time lesson in leverage risk. After the UK's "mini-budget" announced large unfunded tax cuts, gilt yields rose over 100 bps in just 4 days. The consequences unfolded rapidly:
A -> B -> C: Gilt prices collapsed. Leveraged LDI funds faced margin calls. Funds sold gilts to meet margin. Selling pressure pushed yields higher. More margin calls followed.
The numbers tell the story:
- LDI funds sold approximately 25 billion GBP in gilts over 5 weeks
- 30% of that selling occurred in the first 5 days
- LDI selling accounted for roughly half the gilt price decline
- Without Bank of England intervention, gilt yields could have reached 7-8% (from 4.5%)
- Approximately 90% of UK pension funds would have become insolvent
The Bank of England purchased 19.3 billion GBP in gilts to stabilize the market. Crisis averted, but the lesson was expensive (Bank Underground, 2024).
Resilience Standards After the Crisis
Pre-crisis, LDI funds maintained approximately 150 bps of headroom - meaning they could absorb a 150 bps rate shock before facing forced selling. That proved insufficient.
Current requirements are stricter:
- Financial Policy Committee recommends minimum 250 bps resilience
- Most managers now maintain 300 bps buffers
- Pooled LDI funds sold 13 percentage points more gilts than segregated mandates during the crisis (highlighting structure matters)
The durable lesson: leverage works until it doesn't, and rate shocks can exceed historical norms without warning.
Who Uses LDI (And Why)
Defined Benefit Pension Plans represent the largest LDI users. A corporate pension owing $2 billion in future benefits spanning 30 years needs to manage the funding ratio (assets/liabilities) carefully. Regulators and accounting standards require regular funding status disclosure, making liability matching a governance priority.
Insurance Companies apply similar principles for policy reserves. A life insurer with $500 million in annuity obligations must ensure assets generate cash flows matching policyholder payments. Duration mismatch creates earnings volatility that regulators scrutinize.
Endowments with Spending Commitments sometimes adopt liability-aware approaches when grant obligations are predictable and material.
Immunization vs. Cash Flow Matching
Two flavors of LDI exist:
Immunization matches duration and convexity to neutralize rate sensitivity. The portfolio may hold different securities than the liability profile, but the aggregate behavior mimics liabilities closely. More flexible, but requires rebalancing as time passes and bonds mature.
Cash Flow Matching (also called dedication) buys securities whose coupons and maturities precisely match liability payments. A pension paying $5 million in December 2035 buys a bond maturing for exactly $5 million in December 2035. Less flexible, higher certainty, often more expensive.
Most institutional LDI programs blend both - core liability-matching layer plus overlay derivatives for tactical adjustments.
Model Risk and Spread Risk
LDI depends on assumptions that may prove wrong:
Model Risk: Liability calculations use assumptions about discount rates, mortality, salary growth, and benefit elections. A pension using a 6% discount rate versus 5% shows radically different liability present values - potentially 20% or more difference. The CFA Institute notes that model risks arise from assumptions embedded in LDI strategies (CFA Institute, 2026).
Spread Risk: Assets and liabilities don't move perfectly together. Treasuries hedge rate risk, but corporate bonds also move with credit spreads. When spreads widen (as in 2008 or 2020), asset values fall even if liability discount rates stay stable. This basis risk undermines the hedge.
Building a Basic LDI Framework
For institutions exploring LDI, the sequence matters:
Step 1: Quantify liabilities with current assumptions. What is the present value, duration, and cash flow profile?
Step 2: Assess current asset duration. How far from liability-matching is the portfolio?
Step 3: Determine acceptable surplus volatility. How much funding ratio fluctuation can the organization tolerate?
Step 4: Choose instruments. Physical bonds, interest rate swaps, Treasury futures - each has cost and complexity trade-offs.
Step 5: Establish resilience buffers. The 2022 crisis showed 250-300 bps is the new minimum standard.
Essential Considerations Checklist
- Liability duration calculated with current actuarial assumptions
- Asset duration measured consistently with liability methodology
- Leverage ratio defined with clear limits (if derivatives used)
- Stress test results for 200+ bps rate shock scenarios
- Liquidity buffer sized for margin calls under extreme moves
High-Impact Implementation Steps
- Model funding ratio sensitivity to 100 bps parallel rate shift
- Compare immunization cost versus full cash flow matching
- Document governance process for rebalancing triggers
Citation: Leibowitz and Bova (2018) established the theoretical framework for surplus optimization in liability-driven portfolios, demonstrating that duration matching reduces funding ratio volatility by 60-80% versus unhedged approaches.
Source: CFA Institute Liability-Driven and Index-Based Strategies curriculum (2026). UK LDI crisis data from Chicago Fed Letter (2023) and Bank of England analysis.