An introduction to LDI - Insight Investment

AN INTRODUCTION TO LIABILITY DRIVEN INVESTMENTHOW LIABILITIES CHANGEIn order to better manage their funding position, pension schemes must consider the factors that can affect the present value oftheir liabilities. There are three main factors that affect liabilities:Interest ratesLong-term interest rates (typically based around long-dated government bond yields) are used by most pension schemes todetermine the discount rates used to calculate the present value of their liabilities. All else being equal, a fall in interest rates willlead to an increase in that value.InflationBenefit payments are usually linked to inflation, which means that rising inflation forecasts will lead to an increase in projectedpayments, and falling inflation will lead to a fall in projected payments. All else being equal, an increase in the expected level offuture inflation will lead to an increase in the present value of liabilities.LongevityIf pensioners live longer than expected, a pension scheme will have to pay out more benefits over time. This will also increase thesensitivity to changes in inflation and interest rates.The impact of time on present values is significant. Clearly the impact on liability values of changes in all three factors is greaterfor schemes with benefit payments that extend further into the future.Figure 8: How the value of a pension scheme’s liabilities can change 210Annual cash flow (£m)8642InflationLiability risksInterestratesLongevity02012 2032 2052 2072 2092 2112■ Nominal liability cashflows ■ Inflation-linked liability cashflowsIn this example, future payments have been calculated and set out according to their links to inflation. Most pension schemeshave liabilities linked to inflation. Liability risks will have the following effects on a pension scheme’s liabilities:• If expectations for future inflation rise, the present value of liabilities will rise.• If interest rates rise, the present value of liabilities will fall.• If longevity increases, the present value of liabilities will rise.2Source: Insight Investment. For illustrative purposes only.6