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A liability driven investment is a system of asset management that is meant to cover all related costs associated with the investment. This is in addition to the typical practice of striving to get the best returns. It is commonly used with retirement funds and pensions. The goal of a liability driven investment is to manage assets with both current and future costs in mind.
It is most common to use a liability driven investment with pension plans. This is particularly true with defined-benefit plans, which pay an employee benefit for life from the start of retirement. These plans can build up significant fees over time, particularly for high-ranking employees who have the largest pensions. If an action such as liability driven investment is not taken, a pension could end up being underfunded.
At the core of the liability driven investment is a calculation which determines future costs of the fund. This gives the fund manager an idea of what kind of gains will be needed to cover costs. Then an investor will know what amount of cash needs to be invested and how to strategize future investments. Many plans will also have an interest rate hedge, as this can help to manage losses on an investment due to changes in rates.
A typical liability driven investment strategy will include several common elements. One key factor is that lower yield investments such as bonds or money markets preserve the cash needed for current and future liabilities. In some cases cash may be deposited, and, using interest rate swaps, it will be eventually converted to a fixed rate.
Another aspect of liability driven investment strategy is to segment various investments in order to better estimate future costs. In essence, this is the process of separating short and long-term investments so that they can each reach their full potential. This is because it is easier to estimate future costs when assets are essentially frozen, but if there is no movement, then it is not possible to maximize returns. Thus, segmentation allows some movement in some areas, while other segments are ready for estimates of future costs.
Managing a liability driven investment may also include changing expectations to a reduced return on assets (ROA). This typically means that some equities investments may need to be moved to bonds. The costs associated with these changes will usually need to be offset by increased cash outlay from the investor.