Liability Driven Investing

In the previous articles, we have already studied the difference between defined benefit plans and defined contribution plans. We now know that defined-benefit plans promise to pay the retiree a fixed nominal amount whereas defined contribution plans promise to pay the retirees the worth of their investment portfolios.

There is a big difference between the two types of plans. One plan passes the risk of a shortfall to the plan sponsor whereas the other passes it on to the investors. This also means that the investment of both types of plans will also be quite different.

In this article, we will have a closer look at liability-driven investing which is the strategy which is chosen by most defined benefit plans. This is because this approach is used by pension funds to manage the risks on behalf of the sponsor.

What is Liability Driven Investing?

When it comes to managing the funds held by pension funds, the managers generally have two objectives.

  1. One of the objectives is that they want to meet the cash flow needs of the retirees.

  2. The second objective is that they want to maximize the return on investment.

However, these objectives are conflicting. The first one focuses on safety whereas the second one focuses on risk-taking.

Defined contribution pension funds do not pay their retirees a fixed amount. Instead, they pay the market value of investments. Hence, pension funds can afford to take risks in such cases. This approach is more focused on growing the assets of the fund. Hence, it is called an asset-driven investing approach.

A liability-driven investing approach is the opposite of this. In the case of a liability-driven approach, the first objective of the pension fund is to ensure that they are able to pay the liabilities of the fund i.e. the cash flows which need to be paid in the form of pension benefits.

Since the pension benefits are fixed in defined benefit plans, the fund tries to invest in low-risk investments in order to avoid falling short of the payments because if they do fall short of the payments, the sponsor will have to make good the loss.

Hence, liability-driven investing is when the portfolio management team makes an investment with the prime objective of being able to meet the promises and liabilities which the fund has generated over the years.

How Does Liability Driven Investing Work?

The following steps are involved in liability-driven investing:

  1. Pension funds first try to determine their future liabilities. This is done by figuring out the cash flow schedule of the payments that they will have to make in the future

  2. Generally, this is done by understanding the current cash outflow of the investor, projecting it into the future, and then adjusting it based on income that the investor is likely to derive from other sources.

  3. Based on this projection and the contributions, the pension funds work out an internal rate of return that they need to earn. This internal rate of return then becomes the target rate for the pension fund management

  4. The next step is for the pension fund management to seek out equity and debt assets that will enable them to meet the target rate of return. It is important to note the distinction here. In liability-driven investing, the fund does not want to maximize its returns. Instead, they want to reach the target rate of return while taking the minimum risks.

  5. Once, the investments have been made, the liability-driven investment approach suggests that derivatives be used to mitigate the effects of rising inflation and interest rates.

Disadvantages of Liability Driven Investing

This approach of liability-driven investing also has several disadvantages. Two of the most commonly cited disadvantages have been referred to below:

  • The first disadvantage is that there is a huge opportunity cost to this investment system. As mentioned above, risk aversion is the fundamental principle of liability-driven investing. Hence, these funds mostly invest in long-term fixed income instruments.

  • Liability-driven investing is a system where every liability is precisely matched with every asset. This system requires a great deal of planning so that the matching can be done in such a way that funds are made available at the exact moment.

    If funds are available earlier, then there is an opportunity loss. At the same time, if funds are available at a later date, then the pension fund will have to borrow at high costs to meet its short-term need for funds. This is a problem since many times pensioners need to make unplanned withdrawals.

    The coronavirus emergency is an important case in point. Pension funds all over the world faced significant withdrawals on account of covid. Liability-driven pension funds were exposed to a difficult cash flow situation because of this situation.

Hence, it can be said that even though liability-driven investing has several disadvantages, it is not suitable for every situation. This is the reason why there are relatively few takers for this approach today. It is considered to be an idea from the yesteryears which is only suitable if a defined benefit plan is being managed.

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Pension Funds