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What are liability-driven investments and why should you know about them?

IN A NUTSHELL: While most investment strategies focus on maximising returns for investors, liability-driven investments aim to generate sufficient cash flow to cover specific future financial obligations, also called liabilities.

How do investment funds measure performance?

Most traditional investment strategies aim to maximise returns for investors. They typically measure performance relative to a real return (compared with the inflation rate or industry benchmarks such as the Johannesburg Stock Exchange (JSE) All Share Index.

Let’s explain: You invest R10 000 in a unit trust with an investment company. The investment manager invests the money in various assets (shares, property, cash, etc.). By the end of the year, the unit trust’s funds have grown by 9%. However, the inflation rate is 5%, so your real return is only 4%. If the fund wants to grow at the same rate in the next year, we say that it uses a benchmark of inflation + 4% to track performance.

What are liability-driven investments?

Liability-driven investments (LDIs) use a different kind of benchmark to manage their investments. Instead of focusing on creating wealth, an LDI’s primary goal is meeting specific financial obligations in the future.

LDIs are used primarily by institutional investors, such as pension funds and insurance companies, which must make regular future payments to beneficiaries or policyholders, like paying out a pension when a beneficiary retires or a life insurance policy.

These companies must also contend with another uncertainty: time. Although they know they must make payments in the future, they don’t always know when, as a life insurance policy holder could die at 40 or 95.

The payments and their timing are viewed as liabilities. Other factors that LDIs have to take into account are inflation and interest rates, which change over time and can greatly influence the value of investments.

How do LDIs work?

Low risk: Investing in low-risk assets such as cash and bonds because the future income goals are more important than generating overall wealth. Investments that offer high returns can potentially interfere with their goals if their risk is too significant.

Cash-flow matching: Investing in assets that generate cash flows at the same time and amounts as the expected liabilities. This ensures that funds are available when needed. For example, investing in fixed-income bonds or annuities that will provide predictable cash flows and that reach maturity at the same time as the liability.

Dynamic: Regularly monitoring the portfolio’s performance and adjusting the asset allocation and strategies as needed to stay aligned with the changing liabilities.

Protecting against problems: This is also called hedging. They use special tools to protect their investments from changes in interest rates and inflation.

What should trustees know?

In general, LDIs offer stable guaranteed investment returns, thus they are a good way to minimise risk for a retirement fund that regularly pays large amounts of cash in the form of pension payments and death benefits. Always ask your fund manager what measures they have in place to minimise risk.