Swaps: “The hand in the absolute return glove”
May 3rd, 2007 | Filed under: Liability Driven InvestingLiability Driven Investing (LDI) or Liability-Matching, as it is sometimes called, aims to produce a very specific amount of capital at a given point in the future. Not unlike an individual’s own retirement fund, an LDI strategy aims to cover the future costs of paying a group of pensioners a pre-defined amount of money. So even if a pension fund manages to beat the market, it might still fall short of its future commitments if, say, workers all live to 100. Conversely, it might under perform its peers and still meet its liabilities. To calculate a pension’s funding position, actuaries discount these future cash flows back to the present and compare them to the current value of the pension’s assets. As a result, the discount rate used can have a dramatic effect on the present value of these future cash payments.
Unfortunately, pension sponsors have no control over the discount rates used for this calculation. When rates go up, the present value of future payments to pensioners goes down. When rates drop, the present value of those future payments rises.
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