What is the purpose of LDI?

Liability-Driven Investment (LDI) is an investment strategy that focuses on aligning a portfolio with future liabilities, particularly for pension funds or insurance companies. The primary objective of LDI is to ensure that an institution has enough assets to meet its future obligations, typically long-term liabilities such as pension payments or insurance claims.

The essence of LDI lies in its focus on managing risk and ensuring that an entity can meet its future liabilities with minimal volatility. The strategy involves matching the characteristics of assets, such as bonds, with those of the liabilities to reduce exposure to interest rate fluctuations. Essentially, LDI is about managing the financial risks related to the timing and amount of liabilities.

One key feature of LDI is the use of long-duration bonds, which are designed to mimic the cash flows and duration of liabilities. By investing in these bonds, institutions aim to mitigate the impact of interest rate changes, which could otherwise affect the value of their liabilities and assets. The idea is that as interest rates change, the value of liabilities and assets will move in tandem, reducing the overall risk for the institution.

LDI also emphasizes on the management of inflation risk. For example, inflation-linked bonds might be used to ensure that liabilities are protected from the adverse effects of rising inflation, which can erode the purchasing power of future payments. This makes LDI a vital tool for managing the long-term stability of pension funds, especially as life expectancy increases and the duration of liabilities extends.

In summary, the purpose of LDI is to align assets with liabilities in a way that reduces risk, primarily through matching the cash flows of assets with those of liabilities and managing interest rate and inflation risks. It is an important strategy for ensuring financial stability for institutions with long-term obligations.