What is Liability Driven Investment & LDI Pensions?

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What is liability driven investment and how do these strategies affect pensions?

Liability driven investment, often abbreviated to ‘LDI’, is an investment strategy designed to align the pension matching scheme’s assets with its liabilities. LDI strategies are used by Defined Benefit (DB) pension schemes to mitigate risks that cause funding-level volatility due to changes in interest rate and inflation exposures. At its core, LDI seeks to reduce funding volatility and reduce the likelihood of deficit opening and contribution shocks for sponsors.

Read further to learn more about LDI, or visit our XPSArena hub to gain more insight on how you can use LDI effectively when managing scheme risk and long-term planning.

XPSArena LDI Hub

Liability driven investment explained

DB pension schemes face inherent funding volatility due to how actuaries value the liabilities using long-term gilt interest rates and expected inflation (from the inflation gilt market). When long-term gilt interest rates fall, the value of liabilities rises, potentially increasing deficits. Conversely, rising interest rates reduce liability values. Schemes also impact changes in expected market inflation.

Traditionally, UK DB Pension Schemes used to invest their assets into a mixture of equities and bonds, e.g. 60% equities and 40% bonds, often described as a 60:40 portfolio. The strategy primarily balances growth with risk mitigation by combining higher-risk, higher-return assets like equities with lower-risk, more stable assets (bonds). The bonds in the low-risk strategy were not chosen for the matching characteristics to the interest rate and inflation risk of the liabilities. They were instead chosen to provide a low but stable return.

Liability Investment (LDI) was invented in the early 2000s as a response to new accounting standards and pension scheme funding requirements that increased corporate sponsors’ focus on the cost and volatility of meeting defined benefit pension promises. LDI addressed the above by changing the low-risk portfolio to be invested in physical bonds (e.g. gilts) and derivatives to match the interest rate and inflation characteristics of the liabilities (i.e. matching portfolio). As a result, changes in liabilities due to changes in interest rate and inflation are immediately reflected in the matching assets (LDI) and thus reduce funding volatility.

However, LDI is more than matching interest and inflation risk as it also provides contractual inflation increases to the cashflows which broadly match the inflation increases in liabilities.

Due to the value of the matching assets (which typically make up 30%-60% of the portfolio) being materially less than the value of the liabilities being hedged, a moderate amount of leverage is employed to magnify the matching asset returns to match the returns of the liabilities despite the lower value of assets. Trustees and Investment managers closely monitor leverage, and pension schemes have plans to sell some of the growth assets to invest in LDI if LDI leverage becomes too high. Using leverage in LDI DB pension schemes wasn't the source of the gilt crisis in 2022 but was a contributing factor and a key reason for the Bank of England's intervention.

From September to October 2022, gilt yields spiked unprecedentedly due to the unfunded mini-budget from the Liz Truss government. UK DB pension schemes with LDI strategies using leverage had to quickly find liquid growth assets to sell to meet capital calls and deleverage their LDI strategies. Some schemes couldn’t sell the liquid growth assets in time, forcing them to sell gilts to reduce leverage. This created a negative feedback loop, pushing higher yields (prices lower), thus exacerbating the crisis.

To help stabilise the situation, the Bank of England purchased long-dated gilts to restore liquidity and financial stability of the gilt and LDI market. At the same time, pension schemes, with the help of investment managers, increased the capital held within the mandates (i.e. decreased the leverage) by selling other funds. With the increased capital in Pension schemes and the financial support of the Bank of England, the crisis was short-lived, and after a few months, the Bank of England sold back the gilts it had bought at the start of the crisis at a profit.

Regulatory bodies have since been working to improve LDI resilience.

If you’d like to find out more about the gilt crisis, how schemes responded to this, and lessons that were learned since these movements, we have additional resources on XPS Arena.

The LDI crisis gave pension schemes an opportunity to learn from the experience and improve their ability to withstand extreme and volatile market conditions. On November 2022 and April 2023, The Pension Regulator (TPR) guided pension schemes on the amount of capital needed to be allocated within LDI strategies to meet daily and stressed market fluctuations in gilt yields. The TPR also guides how trustee governance supports LDI arrangements.

Separately, The Bank of England conducted stress tests on non-bank financial institutions to assess the resilience of key non-bank financial institutions such as pension funds, hedge funds, and insurers to changes gilt and other financial markets that these investors can take steps better to protect themselves against adverse changes in interest rates, credit spreads and equities.

Regarding immediate and long-term prospects for LDI strategies, industry experts believe they are fit for purpose now that adjustments have been made post-gilt crisis in 2022. Additionally, experts agree that pension schemes need to monitor their LDI investments and ensure their liability hedges are accurate and perform as expected. Currently, most pension scheme performance monitoring is limited to individual funds or cashflow benchmarks. Performance relative to liabilities is often overlooked

Many schemes consider their long-term objectives, whether to run on or transfer their liability obligations to an insurer. Irrespective of what trustees decide, LDI will be the cornerstone of investment strategies in the future, given how liabilities are valued and LDI's role in reducing funding volatility. This is exemplified by the TPR Funding Code which sets a clear expectation that pension schemes should match at least 90% liability interest rate and inflation risks.

Learn more about LDI pensions with XPS

If you’re interested in learning more about LDI funds or if you’d like to explore other options, you can contact a member of our team, visit XPS Arena or visit our service page.

Important information: Please note the information and opinions expressed herein do not take into account the circumstances of individual pension funds and accordingly may not be representative of the circumstances affecting your fund. This note, and the work undertaken to produce it, is compliant with TAS 100, set by the Financial Reporting Council. No other TASs apply. The note has been written on the basis that decisions will not be based on its contents. Appropriate advice should be obtained before any decisions are made. The information expressed is provided in good faith and has been prepared using sources considered to be reasonable and appropriate. While information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This webpage may also include our views and expectations, which cannot be taken as fact. The value of investments and the income from them can go down as well as up as a result of market and currency fluctuations and investors may not get back the amount invested. Past performance is not necessarily a guide to future returns. The views set out in this webpage are intentionally broad market views and are not intended to constitute investment advice as they do not take into account any client’s particular circumstances.

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