Liability-driven Investment Research Articles

Britain's Liability-Driven Investment Episode Was a Canary No One Elsewhere Bothered to Think About

Britain's liability-driven investment crisis in fall 2022 had lessons for other major financial centers that, as evidenced by the US and Swiss banking crises only a few months later, were largely ignored. They are still relevant. In this article, I first discuss what drove the British crisis before identifying lessons for the microregulation of pension funds; for financial stability policy on shadow banking and beyond; for central banking balance sheet regimes, including lending of last resort and market making of last resort; and for monetary policy when fiscal policy makers sit on their hands.

The LDI (Liability-driven Investment) Debacle, Derivatives and Systemic Risk: There You Go Again!

This article examines the role of derivatives in the context of the recent crisis in the UK pension system, specifically in liability-driven investment schemes. It unveils derivatives’ role as instruments that multiply and propagate losses among market participants once specific events (worst-case scenarios) materialise. This article questions the role of derivatives as risk-management and risk-diversification tools, given their employment, in this case as in others before, for speculative purposes. Critically, with speculation came higher than desirable levels of leverage that these financial products elicited, causing in the process a series of systemic concerns. While much criticism has been directed at post-2008 regulation, and particularly at clearing and margin requirements, this article proposes a broader view of the problems posed by derivatives in the different contexts of their applications. More specifically, attention is drawn to legal doctrines that could be redeployed for the purpose of mitigating the speculative nature of derivatives.

Liability-driven investment for pension funds: stochastic optimization with real assets

Using a multi-stage stochastic programming method, we suggest an optimal liability-driven investment (LDI) strategy for a closed defined-benefit pension fund including real assets. The objective is to jointly optimize contribution, funding ratio, and buyout cost, subject to a constraint on downside risk in terms of expected shortfall of assets relative to liabilities. Over a 10-year planning horizon, the optimal LDI strategy with a key-rate duration-matching bond portfolio outperforms the corresponding strategy with a duration-convexity matching bond portfolio as well as a strategy with an aggregate bond index-tracking portfolio. When real assets are introduced, the optimal LDI strategy includes significant investment in infrastructure and real estate, illiquidity notwithstanding. Nevertheless, delays in sales of real assets induced by illiquidity can increase downside risk.

Dynamic Liability-Driven Investment under Sponsor’s Loss Aversion

This paper investigates a dynamic liability-driven investment policy for defined-benefit (DB) plans by incorporating the loss aversion of a sponsor, who is assumed to be more sensitive to underfunding than overfunding. Through the lens of prospect theory, we first set up a loss-aversion utility function for a sponsor whose utility depends on the funding ratio in each period, obtained from stochastic processes of pension assets and liabilities. We then construct a multi-horizon dynamic control optimization problem to find the optimal investment strategy that maximizes the expected utility of the plan sponsor. A genetic algorithm is employed to provide a numerical solution for our nonlinear dynamic optimization problem. Our results suggest that the overall paths of the optimal equity allocation decline as the age of a plan participant reaches retirement. We also find that the equity portion of the portfolio increases when a sponsor is less loss-averse or the contribution rate is lower.

Putting Out the NBFIRE: Lessons from the UK's Liability-Driven Investment (LDI) Crisis

Putting Out the NBFIRE: Lessons from the UK's Liability-Driven Investment (LDI) Crisis

Lessons from the United Kingdom’s Liability – Driven Investment (LDI) Crisis

Lessons from the United Kingdom’s Liability – Driven Investment (LDI) Crisis

Good intentions in risk management and the LDI crisis

This paper describes the part played by repo trading, collateral management and liability driven investment (LDI) strategies (each of which was designed to improve the management of risk) in amplifying the crash in gilt prices following the 23rd September, 2022 UK mini-budget. This was a crisis that ultimately led to the resignations of the British Prime Minister and Chancellor of Exchequer as well as the announcement by the Bank of England of a willingness to spend up to £65bn intervening in the gilt market.1 It argues that neither the government nor the LDI funds were solely responsible for the crash and that the fragilities in the UK financial system had gradually built up over a number of decades. It also looks at the lessons that could potentially be learned by financial institutions using repo trading or collateral management as well as the potential lessons for policy makers in government and regulatory bodies.

Too Many Cooks, Not Enough Risk Management: Gilt Market Dysfunction and Liability-Driven Investment (LDI)

Too Many Cooks, Not Enough Risk Management: Gilt Market Dysfunction and Liability-Driven Investment (LDI)

The LDI (liability-driven investment) debacle, derivatives and systemic risk: there you go again!

The LDI (liability-driven investment) debacle, derivatives and systemic risk: there you go again!

The LDI (Liability-Driven Investment) Debacle, Derivatives and Systemic Risk: There You Go Again!

The LDI (Liability-Driven Investment) Debacle, Derivatives and Systemic Risk: There You Go Again!

Longevity risk—Its financial impact on pensions

We study the financial impact of longevity risk on defined benefit (DB) pension plan liabilities using the 2010 Ghana population census, and the Lee-Carter model. We compare the usual Lee-Carter model to an extended version. While we observe that Ghana’s mortality has decreased, our results show that longevity risk raises the cost of liability. We propose that defined benefit scheme trustees and fund managers, assess their funds and act on the assets available to them in a Liability-Driven Investment (LDI) Strategy tailored to the dynamics of their scheme - since there is no single best method in LDI strategy. This study may help policymakers or practitioners in their efforts to mitigate the effects of longevity risk.

Investment fund selection techniques from the perspective of Brazilian pension funds

ABSTRACT The aim of this article was to evaluate the effectiveness of investment fund selection techniques from the perspective of Brazilian pension funds. Asset liability management (ALM) and liability driven investment (LDI) strategies are usually adopted to guide pension fund managers in relation to strategic allocation in asset classes that should compose their investment portfolios and to the liquidity needed in each period, but not specifying in which assets to allocate resources from among the infinity of assets available in the financial market. This article contributes to tactical management in the fixed income and stock segments outsourced via funds and demonstrates that adopting simple indicators can increase investment performance. The article broadens the knowledge on pension fund investment decisions and creates confidence in the adoption of the Sharpe ratio as a technique for choosing investment funds. We analyzed the returns obtained by hypothetical portfolios built using the following techniques: (i) the Sharpe ratio; (ii) the alpha of a multifactor model; (iii) data envelopment analysis (DEA) efficiency; and (iv) the different combinations of these techniques. We considered information on 369 funds from 2013 to 2018, adopting 12 temporal windows for choosing and re-evaluating the portfolios. The returns obtained were compared with the mean actuarial goal of the benefits plans administered by the pension funds, by means of the unplanned divergence (UD). When outsourcing pension fund investments in fixed income and stock investment funds it was verified that the Sharpe ratio contributes significantly to pension fund performance, compared with other indicators and techniques or a combination of them.

Dynamic surplus optimization with performance- and index-linked liabilities

The increasing importance of liability-driven investment strategies and the shift towards retirement products with lower guarantees and more performance participation provide challenges for the development of portfolio optimization frameworks which cover these aspects. To this end, we establish a general and flexible terminal surplus optimization framework in continuous time, allowing for dynamic investment strategies and stochastic liabilities, which can be linked to the performance of an index or the asset portfolio of the insurance company. Besides optimality results in a fairly general surplus optimization setting, we obtain closed-form solutions for the optimal investment strategy for various specific liability models, which include the cases of index-linked and performance-linked liabilities and liabilities which are completely or only partially hedgeable. We compare the results in numerical examples and study the impact of the performance participation, unhedgeable risk components, different ways of modeling the liabilities and the relative risk aversion parameter. We find that performance- or index-linked liabilities, which provide a close link between the wealth of the insurance company and its liabilities, allow for a higher allocation in the risky investment. On the other hand, unhedgeable risks reduce the allocation in the risky investment. We conclude that, aiming at a high expected return for the policy holder, insurance companies should try to connect the performance of insurance products closely to the wealth and minimize unhedgeable risks.

Immunization Strategies for Funding Multiple Inflation-Linked Retirement Income Benefits

Protecting against unexpected yield curve, inflation, and longevity shifts are some of the most critical issues institutional and private investors must solve when managing post-retirement income benefits. This paper empirically investigates the performance of alternative immunization strategies for funding targeted multiple liabilities that are fixed in timing but random in size (inflation-linked), i.e., that change stochastically according to consumer price or wage level indexes. The immunization procedure is based on a targeted minimax strategy considering the M-Absolute as the interest rate risk measure. We investigate to what extent the inflation-hedging properties of ILBs in asset liability management strategies targeted to immunize multiple liabilities of random size are superior to that of nominal bonds. We use two alternative datasets comprising daily closing prices for U.S. Treasuries and U.S. inflation-linked bonds from 2000 to 2018. The immunization performance is tested over 3-year and 5-year investment horizons, uses real and not simulated bond data and takes into consideration the impact of transaction costs in the performance of immunization strategies and in the selection of optimal investment strategies. The results show that the multiple liability immunization strategy using inflation-linked bonds outperforms the equivalent strategy using nominal bonds and is robust even in a nearly zero interest rate scenario. These results have important implications in the design and structuring of ALM liability-driven investment strategies, particularly for retirement income providers such as pension schemes or life insurance companies.

Liability-Driven Investment for Pension Funds: Stochastic Optimization with Real Assets

Using a multi-stage stochastic programming method, we suggest an optimal liability-driven investment (LDI) strategy for a closed defined-benefit pension fund including real assets. The objective is to minimize or stabilize contributions, funding ratio, buyout cost, and expected shortfall. Over a 10-year planning horizon, the optimal LDI strategy with a key-rate duration-matching bond portfolio outperforms one with a duration-convexity matching bond portfolio or an aggregate bond index-tracking portfolio in terms of the objective measures. When real assets are introduced, the optimal LDI strategy includes significant investment in infrastructure and real estate, illiquidity notwithstanding. Nevertheless, delays in sales of real assets induced by illiquidity can increase downside risk.

A global investment opportunity in non-listed infrastructure for institutional investors

PurposeInfrastructure investment is one of the few high-calibre real alternative assets with a strong prominence in the portfolios of institutional investors, especially those with a liability-driven investment strategy. This has seen increased institutional investor interest in infrastructure for reasons such as diversification benefits and inflation hedging abilities, resulting in the substantial growth in non-listed and listed investment products offering access to the infrastructure asset class, and complementing the existing route via direct investment. This paper aims to assess the investment attributes of non-listed infrastructure over Q3:2008–Q2:2019, compared with other global listed assets of infrastructure, property, stocks and bonds.Design/methodology/approachQuarterly total returns were derived from the valuation-based MSCI global non-listed quarterly infrastructure asset index over Q2:2008–Q:2019, which were then filtered to decrease the valuation smoothing effects. A similar set of returns data was also collected for the other global asset classes. The average annual return, annual risk, risk-adjusted performance and portfolio diversification benefits for non-listed infrastructure and other asset investment classes were then computed and compared. Lastly, a constrained optimal asset allocation analysis was performed to validate the performance enhancement role of global non-listed infrastructure in a mixed-asset investment framework.FindingsGlobal non-listed infrastructure delivered the strongest average annual total return performance, outperforming the other asset classes and provided investors with total returns that linked strongly with inflation. Global non-listed infrastructure also provided investors with one of the least volatile investment returns because of its ability to ensure predictable total returns delivery. This means that on the Sharpe ratio risk-adjusted return basis, non-listed infrastructure was also the strongest performing asset. This performance was also delivered with significant portfolio diversification benefits with all assets, resulting in non-listed infrastructure contributing to the mixed-asset portfolios across the entire portfolio risk spectrum.Practical implicationsAside from better risk-return trade-offs, institutional investors are getting more secular with their portfolios for alternative assets that are able to provide other investment benefits such as predictable long-term performance and inflation-linked returns. A further improvement in performance and diversification benefits could be achieved by enriching existing investment portfolios with real alternative assets, one of which is the infrastructure asset class. For institutional investors, having exposure to and being part of the development, delivery and management of infrastructure assets are important, as they are one of the few real assets having considerable significance in the context of society, economy and investment needs.Originality/valueThis is the first research paper that empirically investigates the investment attributes of the non-listed infrastructure at a global level. This research enables empirically validated, more informed and practical decision-making by institutional investors in the infrastructure asset class, especially via the non-listed pathway. The ultimate aim of this paper is to empirically validate the strategic role of non-listed infrastructure as an important alternative asset in the institutional real asset investment space, as well as in the overall portfolio context.

Dynamic Surplus Optimization with Performance- and Index-Linked Liabilities

The increasing importance of liability-driven investment strategies and the shift towards retirement products with lower guarantees and more performance participation provide challenges for the development of portfolio optimization frameworks which cover these aspects. To this end, we establish a general and flexible terminal-surplus optimization framework in continuous time, allowing for dynamic investment strategies and stochastic liabilities, which can be linked to the performance of an index or the asset portfolio of the insurance company. Besides optimality results in a fairly general surplus optimization setting, we obtain closed-form solutions for the optimal investment strategy for various specific liability models, which include the cases of index-linked and performance-linked liabilities and liabilities which are completely or only partly hedge-able. We compare the results in numerical examples and study the impact of the performance participation, un-hedge-able risk components, different ways of modeling the liabilities and the relative risk aversion parameter. We find that performance- or index-linked liabilities, which provide a close link between the wealth of the insurance company and its liabilities, allow for a higher allocation in the risky investment. On the other hand, un-hedge-able risks reduce the allocation in the risky investment. We conclude that, aiming at a high expected return for the policy holder, insurance companies should try to connect the performance of insurance products closely to the wealth and minimize un-hedge-able risks.

Practical Applications of Liabilities Matter: Improving Target Date Glidepath Construction through Liability Adaptive Asset Allocation

Practical Applications Summary In Liabilities Matter: Improving Target Date Glidepath Construction through Liability Adaptive Asset Allocation, from the Summer 2019 issue of The Journal of Retirement, author Michael W. Crook (of UBS Global Wealth Management in New York, NY) calls into question the rationale behind the most popular investment funds in today’s employee defined-contribution (DC) plans. Target date funds (TDFs)—which, for example, are held by 75% of participants in DC plans managed by Vanguard—use a preset schedule called a glidepath to reallocate assets from equities to fixed-income securities as a participant’s retirement date approaches. The author finds that this approach does not work as well as the liability-driven investment (LDI) strategy used by pension plans. LDI is more responsive to the needs of participants because it focuses not on participants’ retirement dates, but on how close they are to having enough money on which to retire. It reallocates assets to fixed-income securities as a participant’s plan balance approaches the amount needed to fund all retirement expenses. The author finds that LDI produces better outcomes, is easier to explain to clients, and makes it easier for financial advisors to provide customized financial planning and total wealth management for their clients.

Managing Capital Market Risk for Retirement

We offer an overview of solutions available to pension plans to manage capital market risk in order to meet their obligations. We outline the main drivers behind the evolution of asset-liability management (ALM) for pension plans and the emergence of liability-driven investment (LDI) in the last decade. We look at some of the most popular pension de-risking tools and at recent innovations prompted by the Global Financial Crisis. We offer examples based on the rise of cross-asset correlation, the use of hybrid products to mitigate tail risk, and the increasing relevance of counterparty risk mitigation tools such as collateralization. We conclude by outlining some of the main challenges ahead, including developments in pension regulation, centralized clearing of over-the-counter (OTC) instruments, and risk taking incentives in delegated asset management for long term retirement obligations.

Why Pairing LDI with De-Risking Glide Paths Produces Inferior Pension Fund Outcomes

Combining traditional Liability Driven Investment (LDI) with funded status responsive de-risking strategies involves inconsistent treatment of risks in these two elements of what has become a popular pension strategy. This inconsistency causes irreconcilable conflicts in their execution and imperils the positive pension fund outcome. This article provides a critique of the combined LDI/De-risking Glide Path strategy as currently implemented by many pension plan managers and also provides an example of an alternative solution that improves pension plan outcomes. Our prescription for the pension de-risking glide path approach differs from conventional wisdom, resulting in faster de-risking, without undesirable market betas that are unrelated to the liability. It also avoids illiquid assets that pension funds often gravitate toward in their quest for returns, takes fewer credit risks, and seeks more alpha risks.