What it means
A defined benefit pension scheme promises to pay members fixed amounts in the future, and the value today of those promises is its liability. That value is found by discounting the future payments using an interest rate, so when rates fall the liability rises, and when rates rise it falls.
If the scheme's assets do not move the same way, the gap between assets and liabilities can open up even when markets are calm. LDI tackles this mismatch by choosing assets whose value reacts to interest rates in a similar way to the liabilities.
The key measure is duration, which describes how sensitive a value is to a change in rates. Long-dated government bonds, interest rate swaps and similar instruments are typically used to give the assets a duration close to that of the liabilities.
A hedge ratio expresses how much of the liability's interest rate sensitivity has been matched. A scheme with a 100% hedge ratio would be fully protected against rate moves, while 50% leaves half of the exposure open.
Many schemes hedge only part of the risk, because full hedging can require large amounts of leverage (borrowing or derivatives) and ties up capital. For a finance professional, LDI changes the question from "how much did we earn?" to "how did our funded ratio move?".
It is also used by insurers and some corporate treasuries that have long-term obligations. The funded ratio, assets divided by liabilities, becomes the main yardstick of success.
The nuance is that LDI brings its own risks. Leveraged hedging can lead to sudden demands for cash, called collateral calls, when interest rates move sharply, and this has caused serious problems in past market episodes.
Schemes therefore need a buffer of liquid assets and clear governance.
In practice
Real-world examples.
Example
A manufacturing company's pension scheme is 90% funded and its trustees worry about falling interest rates. They shift part of the portfolio into long-dated government bonds and swaps. The scheme's funded ratio becomes far less sensitive to rate moves.
Example
An insurer sells annuities that pay a fixed income for life, creating liabilities that stretch 25 years. Its investment team buys long-term bonds so that the assets respond to interest rates in much the same way as the annuity obligations. The insurer's reported solvency stays steady when rates move.
Example
A university endowment must fund a $200 million building programme with payments spread over 10 years. Its treasurer holds bonds maturing as each payment falls due so the cash arrives when needed. The approach removes the risk of having to sell growth assets at a bad time.
Formula
Calculation
Funded ratio = assets / liabilities. Hedge ratio = (asset duration x assets) / (liability duration x liabilities)
A pension scheme has liabilities of $100 million with a duration of 15 and assets of $90 million, so its funded ratio is 90 / 100 = 90%. If its assets have a duration of 6, the hedge ratio is (6 x 90) / (15 x 100) = 540 / 1,500 = 36%. A fall in rates of 1 percentage point raises liabilities by about 15%, to $115 million, and raises assets by about 6%, which is $5.4 million, to $95.4 million, so the funded ratio drops to 95.4 / 115 = 83.0%. With an LDI strategy that lifts asset duration to 15, assets rise by 15% to $103.5 million, and the funded ratio stays at 103.5 / 115 = 90.0%.Case study
Seen in the real world.
Falconbridge Industries is an illustrative, fictional manufacturer whose pension scheme had liabilities of $400 million and assets of $360 million. For two years, the scheme's assets were invested mostly in shares, and when interest rates fell the liabilities jumped by $60 million while assets barely moved, widening the deficit.
The trustees and the finance director agreed to adopt an LDI approach, moving half the assets into longer-dated bonds and swaps to hedge roughly 70% of the interest rate risk. The next time rates moved by one percentage point, the funded ratio shifted only a small amount instead of falling several points. The illustrative lesson is that LDI trades some potential for upside for much greater certainty about the funding position, while also requiring careful planning for collateral calls.
Watch out
Common mistakes.
- Treating LDI as a way to boost investment returns, when its purpose is to reduce the mismatch between assets and liabilities.
- Ignoring liquidity, so that a leveraged hedge triggers a cash call the scheme has no easy way to meet.
- Hedging against interest rates but forgetting inflation, when many pension promises rise with inflation and need inflation-linked assets too.
Questions
People also ask.
Who uses LDI?
Defined benefit pension schemes are the main users, but insurers, endowments and some corporate treasuries with long-dated obligations use similar ideas.
What is the difference between LDI and a normal portfolio?
A normal portfolio aims to beat a market benchmark, while LDI measures success against the scheme's own liabilities and tries to keep the funded ratio stable.
Does LDI remove all risk?
No. It reduces interest rate and inflation risk but leaves other risks, such as longevity, credit and the liquidity demands of the hedging instruments.
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