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of successive years. An LDI strategy was
formed by mixing investments in different
`buckets' in the right amounts. This is a
compromise that produces what appears to
be a materially less precise match but, in
fact, the residual risk is surprisingly small
-- and is still a vast improvement on using
bonds for this task. This aspect is sometimes
misunderstood but greater comfort with
LDI in general seems to be bringing greater
acceptance of a more pragmatic viewpoint.
Under the bonnet
First generation LDI funds typically contained
an interest rate swap contract for each year's
cash flow. These provided a hedge for the
interest rate risk in the relevant cash flows.
These swaps were fully backed by cash holdings,
so a �100 investment was required to hedge a
cash flow with a present value of �100.
What you ended up with was a cash flow
hedge with the right timings, and an average
term that was much longer than the bonds
that normally provided schemes' liability-
matching element but you remained locked
into a low rate of return by the high cash
exposure. This is fine if you had only assumed
low returns (often true for pensioner liabilities)
and didn't want higher returns to help with a
deficit or future accrual, but these schemes are
in the minority.
Partial funding or (deep
breath) leverage
The second generation of funds began to
address this by requiring only 50% of the
value of the cash flow being hedged to be
invested. The swaps themselves do not
require an up-front payment but are simply
designed to increase or decrease in value in
line with the liabilities as interest rates fall
or rise. When they do, the LDI funds make
or receive a payment from the investment
bank. The cash in LDI funds acts as the
source for these payments, so we only need
enough to cover the potential fall in value.
Unless interest rates rise by a large amount,
a 50% cash holding should be plenty.
This means that there is cash left over to
invest in something a bit more interesting,
with the possibility of producing higher
returns. This is good news for pension
schemes, especially if the funding
assumptions imply something more than
cash returns. Since this is often the case for
non-pensioner liabilities, we suddenly have
the prospect of applying an LDI strategy
to assets backing actives and deferred
pensioners, while still being able to meet the
required return assumption.
InvestmentLDI
October 2008 29
Figure 2: The evolution of LDI
First generation LDI
Latest generation LDI
Second generation LDI
Liabilities
Portfolio structure
LDI swap overlay
Cash
Liabilities
Portfolio structure
LDI swap overlay
Cash
Liabilities
Portfolio structure
LDI swap overlay
Cash
Return-seeking
assets
Return-seeking assets

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