Liability Driven Investment (LDI) Investing based on your expenses
Many investment strategies seek the highest possible return. In contrast, a Liability Driven Investment Strategy seeks to provide stable income.
Most retirees have a good understanding of what their common expenses are. They know how much they spend on housing, food, and travel. Some can even predict how much they are going to spend next year or the next five years. But very few people have any idea how much money they will need 10 years from now. And they are even less certain how much money they will need to cover their lifetime of expenses. How long will you live? How long will your spouse live? Unless you are an actuary, you probably haven't calculated your joint life expectancy.
Plus, people face other sources of uncertainty. They may be uncertain of how much any item will cost in the future or how much of it they might consume. They do not have any idea what future inflation rates may be and how it will affect their consumption.
Few people have a plan for how to invest to protect against inflation. A recent survey found that more than half of respondents had one plan for inflation: they would just consume less.
People also don't know the future of financial markets. Interests rates might go up or down. The stock market might crash, or economic growth might be lower in the future.
An LDI strategy helps with this uncertainty by doing the following:
1. It Establishes a Timeline
A good LDI strategy starts with determining how long the money you saved will need to last. Then it creates a realistic timeline over which expenses can be covered each year.
2. It Ensures that Income Is Available
The strategy will invest in bonds with maturities that are similar to the liabilities. In other words, the income is available when the bills need to be paid no matter what happens to financial markets. The income is a combination of coupon payments and maturing bonds.
3. It Plans for Inflation
The strategy addresses inflation by investing in inflation-protected government bonds. These bonds promise to pay an interest rate plus an inflation rate. The United States government makes this promise.
The simple goal of the any LDI strategy is to ensure that the consumer can pay for all future expenses. While most investment strategies are chasing returns, an LDI strategy pursues stable income and provides peace of mind. This is the same strategy insurance companies and pension funds have used to provide people with stable income for years.