Liability-Driven Investing: Matching Assets to Financial Obligations

Liability-driven investment (LDI) is a portfolio construction approach that starts not with return maximisation but with a specific financial liability — a future obligation — and works backwards to determine what assets should be held to match or hedge that liability. The strategy became prominent in corporate defined benefit (DB) pension management, but its principles are highly relevant to wealthy individuals with significant, quantifiable future financial obligations.

The 2022 UK LDI crisis — in which leveraged LDI strategies used by DB pension funds caused a near-collapse of the gilt market and required emergency Bank of England intervention — brought the concept to wide public attention. Understanding what went wrong in 2022, and what legitimate LDI can achieve, is important for sophisticated investors.

This guide is for general information only and does not constitute investment or actuarial advice. LDI strategies involve complexity, cost, and risk, including the risk of capital loss. Seek independent professional financial advice.

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What Is a Liability?

In investment terms, a liability is a future obligation to pay money. For a defined benefit pension fund, the liability is the stream of pension payments owed to beneficiaries — calculated as the present value of all future pension payments, discounted at an appropriate rate. For a wealthy individual, liabilities might include:

• A specific lump sum needed in 10 years (e.g., to fund a property purchase, a business buyout, or a child's education)
• Ongoing income requirements from a portfolio (e.g., to fund lifestyle expenses in retirement)
• A fixed obligation to make a payment on a specific date (e.g., a promissory note, a deferred tax liability, a commitment to a private equity fund)

The insight of LDI is that managing a portfolio is not just about maximising returns — it is about managing the relationship between the portfolio's value and the liability it is meant to fund.

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The Core Concept: Matching vs Mismatching

A Simple Example

Suppose an investor knows they must pay £5 million in exactly 10 years to fulfil a financial commitment. They have £4 million today to invest.

Option A: Invest in equities seeking 6% per annum real return, hoping to grow to £5m+. If equities return 6%, they reach approximately £7.2m — more than enough. But if equities fall 40% at year 9, the portfolio may be worth only £4m when the obligation falls due.

Option B: Buy a 10-year gilt strip (a zero-coupon bond) that matures at exactly £5 million in 10 years. At current yields, the cost of this strip is approximately £4m. There is no uncertainty about meeting the obligation — the asset and liability are perfectly matched. The cost is foregone upside.

Most investors choose somewhere between these extremes — holding some matching assets for certainty on critical obligations and some return-seeking assets for potential upside.

Duration Matching

The most important measure in LDI is duration — the sensitivity of an asset (or liability) value to changes in interest rates. A liability discounted at current interest rates has a duration: if rates fall by 1%, the present value of the liability rises (because you need more money today to meet the same future obligation). A matching asset should have the same duration, so that rate movements affect the asset and liability equally, keeping the "surplus" (assets minus liabilities) stable.

For a pension fund with 20-year average liability duration, holding 20-year gilts achieves duration matching. Holding 3-year gilts leaves a large duration mismatch — interest rate changes cause the asset and liability values to diverge.

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The 2022 UK LDI Crisis: What Happened

UK defined benefit pension funds had collectively adopted LDI strategies using leveraged gilt positions to hedge their liability duration. Leverage was employed because many funds were in deficit — they had insufficient assets to buy enough gilts to match liabilities at face value. By using gilt repos (borrowing money against gilt collateral to buy more gilts), funds could achieve duration matching with fewer actual assets, freeing up capital for return-seeking assets like equities and alternatives.

When the Truss government's "mini-budget" in September 2022 caused gilt yields to spike sharply and rapidly (the 30-year gilt yield rose approximately 150 basis points in a matter of days), the mark-to-market value of the leveraged gilt positions fell sharply. Funds received "margin calls" — demands for additional collateral to maintain the leveraged positions. To meet these calls quickly, funds were forced to sell gilts — which further drove gilt yields up — creating a self-reinforcing spiral.

The Bank of England intervened with emergency gilt purchases to break the cycle.

The lesson drawn by most commentators is not that LDI is inherently flawed, but that excessive leverage within LDI is dangerous — and that liquidity buffers must be adequate to absorb rate movements without forced selling. Post-2022, LDI strategies have been de-leveraged and liquidity requirements have been strengthened by TPR (The Pensions Regulator).

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LDI Principles for Individual Investors

While corporate pension LDI involves pooled strategies and derivatives, the underlying principles translate directly to individual wealth management:

Identify and Quantify Liabilities

The starting point is defining what your liabilities are. This requires:

• Amount: How much do you need to pay, or what income do you need?
• Timing: When exactly (or in what range of dates) does the obligation fall due?
• Inflation linkage: Is the obligation fixed in nominal terms, or does it grow with inflation?
• Certainty: Is the obligation contractual and certain, or estimated and variable?

A highly certain, inflation-linked liability (e.g., a contractual obligation growing at RPI) is best hedged with an inflation-linked asset. A less certain, nominal liability (e.g., estimated retirement income needs) requires more flexibility.

Match Duration for Critical Liabilities

For obligations that are certain in amount and timing, holding assets of matching duration and credit quality eliminates interest rate risk on that portion of the portfolio. This might mean holding:

• UK index-linked gilts for inflation-linked obligations (pension income, inflation-adjusted commitments)
• Nominal gilts or investment-grade bonds of matching maturity for fixed-amount obligations
• Money market funds or short gilts for near-term liquidity needs

Separate Matching Portfolio from Growth Portfolio

A practical framework divides a portfolio into two distinct parts:

1. Matching portfolio (or "liability-hedging portfolio"): Assets chosen to replicate the characteristics of known liabilities. Typically bonds and inflation-linked securities. Low expected return but predictable.

2. Return-seeking portfolio: Assets chosen for expected return — equities, alternatives, property, private equity. Higher expected return but subject to market risk.

The size of the matching portfolio depends on the certainty and importance of the liabilities. A contractual obligation to make a specific payment in 5 years should be largely in the matching portfolio. A desired but non-contractual retirement income goal can tolerate more growth portfolio exposure.

Avoid Leverage Unless Fully Managed

The 2022 crisis illustrates the risk of leveraging the matching portfolio. Unless you have sophisticated risk management, daily mark-to-market monitoring, and adequate liquid buffers, leveraged duration exposure can force selling at precisely the wrong moment.

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Practical Applications for Wealthy Individuals

Education Funding

If you have a child aged 8 and intend to fund university fees and living costs from age 18 — a roughly £100,000–£200,000 obligation in 10 years — a partial matching strategy using a 10-year gilt or structured deposit de-risks a proportion of that obligation, while allowing a growth allocation for the remainder.

Property Purchase or Business Commitments

A property purchase commitment in 3 years, or a capital call commitment to a private equity fund, represents a near-certain obligation. Holding the relevant capital in short-duration bonds or money market instruments, rather than in equities, eliminates the risk of a market downturn leaving you unable to meet the commitment.

Retirement Income Planning

A wealthy retiree requiring, say, £200,000 per annum in inflation-adjusted income may hold a portion of their portfolio in UK index-linked gilts (which provide RPI-linked income) and a portion in equities (which provide long-term real return). The index-linked component funds the "floor" of retirement income regardless of market conditions; the equity component funds discretionary spending and real portfolio growth.

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Cost Considerations

Duration-matching assets (gilts, index-linked gilts) typically offer lower expected returns than growth assets. An LDI allocation therefore has an "opportunity cost" — expected return foregone relative to a fully growth-oriented portfolio. Whether that cost is worthwhile depends on the importance and certainty of the specific liability.

In environments where gilt yields are meaningfully positive in real terms (as in 2023–2026, with index-linked gilts offering positive real yields), the cost of matching is lower than in the 2010–2021 period when real gilt yields were deeply negative. This makes LDI-informed portfolio construction more attractive in the current environment.

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How Global Investments Can Help

Global Investments works with internationally mobile HNW clients on comprehensive portfolio construction, including the identification and hedging of significant future financial obligations. We can help you map your known and estimated liabilities, assess the appropriate allocation between liability-matching and return-seeking assets within your portfolio, and recommend specific instruments — gilts, index-linked bonds, structured products — to hedge critical obligations efficiently. We take into account your domicile, tax position, and currency exposures when recommending matching instruments.