How do you implement a liability-driven investing (LDI) strategy?

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AcadiFi · Accepted Answer

LDI implementation proceeds through liability analysis, hedge design, overlay construction, and ongoing governance. Step 1: decompose the liability. Compute key-rate durations at each tenor (2y, 5y, 10y, 20y, 30y), inflation sensitivity for COLA-indexed benefits, and longevity sensitivity. For Mereford Cardinal Pension with 14-year overall duration, the liability KRDs might be 1.5y (short-term benefits), 3.2y (10y), 5.8y (20y), 3.5y (30y-plus). Step 2: design the hedging portfolio. Physical long bonds provide capital-efficient hedging but tie up cash; swaps and STRIPS enable leverage. A mix of long Treasury STRIPS and receive-fixed interest-rate swaps can replicate the liability KRDs with less capital. Step 3: build the return-seeking portfolio on the remaining assets — global equity, private credit, infrastructure, real assets. Step 4: set the hedge ratio. Full hedging (100%) removes rate risk entirely; partial hedging (70-80%) preserves some upside. Step 5: govern. Daily monitor hedge ratio drift, quarterly rebalance, annual policy review. Common challenges. Convexity mismatch: liabilities have positive convexity; long bonds do too, but swaps less so. Liquidity: in stress (e.g., UK 2022 gilt crisis), LDI funds faced collateral calls that forced forced selling. Lesson: maintain liquidity buffers and stress-test collateral needs under severe scenarios (200bp rate shock). Our CFA Level III LDI module covers implementation through case studies.

How do you implement a liability-driven investing (LDI) strategy?

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