Portfolio Management Pathway · Liability-Driven and Index-Based Strategies

Liability-Driven Investing Basics for CFA Level III

Updated 8 October 2026 · Fact-checked

Liability-driven investing (LDI) sets the asset portfolio by the size, timing and risk of the liabilities it must fund. The goal is to manage the surplus (assets minus liabilities), not asset return alone. To solve questions, identify the liability type, measure its duration and certainty, then choose assets and a hedge ratio.

Understand Liability-Driven Investing Basics

Most investors start with an asset-only approach. They pick the mix that gives the best expected return for a given asset risk. Liabilities are in the background. This works when there is no fixed obligation, such as for many individuals.

Some investors owe money in the future. Examples are a defined benefit (DB) pension plan, a life insurer and a bank. For them, asset risk is the wrong measure. A portfolio can look safe and still fail to pay the liabilities. Liability-relative approaches judge assets against the liabilities. The key outcome is the surplus (or funded status): asset value minus the present value of liabilities. Surplus risk is the variability of that surplus.

LDI is the liability-relative approach. You first describe the liabilities: their amount, timing, interest rate sensitivity (duration), inflation link and how certain they are. Then you build assets whose value moves with the liabilities. A common split is a liability-hedging portfolio (often bonds matched to liability duration or cash flows) and a return-seeking portfolio (growth assets that aim to earn the surplus).

Liabilities differ by investor:

DB pension plan: long-dated benefit payments, often linked to salary or inflation. Discounted at a rate tied to high-quality bond yields, so liability value is highly sensitive to interest rates and long in duration. Timing depends on retirement, mortality and plan demographics.
Life insurer: liabilities are policy payments. Some are fairly predictable (annuities), others depend on death or surrender. Insurers often aim to fund liabilities with assets that match cash flows and manage spread, credit and reinvestment risk.
Non-life (property and casualty) insurer: claims are uncertain in amount and timing, so liquidity and short duration matter more.
Bank: liabilities are mainly deposits and borrowings, short and often callable by the depositor. Assets are loans, often longer. The focus is the gap between asset and liability duration, liquidity and funding risk.

The more certain and longer the liabilities, the more the portfolio is driven by them. The greater the plan's funded status and the sponsor's ability to bear risk, the more room there is for return-seeking assets. A weak sponsor or an underfunded plan lowers risk capacity. Always tie the allocation back to this liability profile and the investor's constraints.

Key rules to remember

Surplus: Surplus = Market value of assets − Present value of liabilities; Negative surplus means underfunded. LDI manages the variability of this number.
Funded ratio: Funded ratio = Assets ÷ PV of liabilities; Below 1 means a deficit. Use the same discounting basis for the liabilities each time.
Change in surplus: ΔSurplus = ΔAssets − ΔLiabilities; Surplus risk comes from assets and liabilities not moving together.
Duration approximation of value change: %ΔValue ≈ −Duration × ΔYield; Apply to assets and to liabilities separately, then convert to currency changes.
Duration gap (value basis): Hedge works when Asset value × Asset duration = Liability value × Liability duration; Matching durations alone is not enough if values differ. Match the currency sensitivity (money duration).
Surplus variance: σ²(S) = σ²(A) + σ²(L) − 2 × Cov(A, L); Higher correlation between assets and liabilities lowers surplus risk. Use currency amounts or consistent weights.

How to solve Liability-Driven Investing Basics questions

Use this order for any LDI question. It keeps your answer tied to the liabilities and the client.

1Identify the investor type: DB plan, life insurer, non-life insurer or bank.
2Describe the liabilities: size, timing, duration, inflation or salary link, and certainty.
3State the funded status and the sponsor's or institution's ability to bear risk.
4Choose the approach: asset-only, or liability-relative with a hedging portfolio and a return-seeking portfolio.
5Do any calculation: surplus, funded ratio, or change in assets and liabilities from yield moves using money duration.
6Pick assets that match the liability profile (duration, cash flows, inflation link) and set how much goes to growth assets.
7Justify in one or two sentences by linking your choice to liability characteristics and constraints.

Quickest way: Surplus-first shortcut

When to use it: Use for calculation or direction questions on how a yield change affects funded status.

Compute assets and liabilities in currency terms.
Compare money duration: asset value × duration against liability value × duration.
If liability money duration is larger, falling yields hurt the surplus. If asset money duration is larger, rising yields hurt it.
Estimate ΔA and ΔL with −Duration × Δy × value, then subtract for ΔSurplus.
State the conclusion in one line.

Common mistakes in Liability-Driven Investing Basics

Matching asset and liability durations without checking values
Students see 'duration match' and stop, forgetting that duration is a percentage sensitivity.
Fix: Compare money durations: value × duration. When assets are smaller than liabilities, the asset duration must exceed the liability duration so that the money durations are equal: asset duration = liability duration × PV liabilities ÷ asset value.
Judging the plan by asset return or asset volatility only
Asset-only habits from earlier levels carry over.
Fix: Measure risk and success by the surplus. A low-volatility asset mix can still produce high surplus risk.
Treating all liability-driven investors alike
Memorising one DB-plan template.
Fix: Separate the profiles: DB plans are long and rate-sensitive, life insurers are cash-flow matched, non-life insurers need liquidity, banks manage a short-liability funding gap.
Ignoring inflation or salary links in pension liabilities
Liabilities are treated as fixed nominal cash flows.
Fix: If benefits are indexed, nominal bonds hedge poorly. Consider inflation-linked assets and say why.
Recommending high growth allocation for an underfunded plan with a weak sponsor
Focusing on the need for return and ignoring ability to take risk.
Fix: Low funded status and weak sponsor finances reduce risk capacity. Favour more hedging assets and state the reasoning.

Worked examples

Example 1

A DB plan has assets of 800 million and liabilities with a present value of 1,000 million. Asset duration is 6 and liability duration is 12. Yields fall 0.5% across the curve. Estimate the change in surplus and state what the result means.

Show the solution

Starting surplus = 800 − 1,000 = −200 million (funded ratio 0.80).
ΔAssets ≈ −6 × (−0.005) × 800 = +0.03 × 800 = +24 million.
ΔLiabilities ≈ −12 × (−0.005) × 1,000 = +0.06 × 1,000 = +60 million.
ΔSurplus = 24 − 60 = −36 million.
New surplus ≈ −236 million.
Liability money duration is 12 × 1,000 = 12,000. Asset money duration is 6 × 800 = 4,800. The plan is exposed to falling yields.

Answer: Surplus falls by about 36 million to about −236 million. The plan is under-hedged: liabilities are more rate-sensitive than assets, so falling yields widen the deficit.

Example 2

A plan sponsor asks whether a 100% global equity portfolio is suitable for its DB plan, which is 90% funded and has a financially weak sponsor. The liabilities are long and inflation-linked. Recommend an approach in brief.

Show the solution

The liabilities are long-duration and inflation-linked, so they are highly sensitive to rates and inflation.
Equity returns are weakly and unreliably correlated with liability changes, so surplus risk would be high.
The plan is underfunded and the sponsor is weak, so ability to take risk is low.
Use a liability-relative approach. Build a hedging portfolio of long-duration bonds with inflation-linked bonds to match rate and inflation sensitivity.
Keep a smaller return-seeking portfolio to help close the funding gap, sized within risk capacity.

Answer: Do not hold 100% equities. Adopt LDI: a larger liability-hedging portfolio of long-duration and inflation-linked bonds matched to liability sensitivity, plus a limited return-seeking portfolio. Underfunding and a weak sponsor lower risk capacity, and equities do not track the liabilities.

Exam tips

When the command word is 'justify' or 'recommend', name the liability trait (duration, inflation link, certainty) and link it to your asset choice.
Show surplus calculations in currency terms. A correct number typed alone earns full credit, but show a line of working in case of a slip.
Contrast asset-only and liability-relative in one sentence: the first targets asset risk and return, the second targets surplus.
For insurers and banks, give each a distinct focus: cash flow matching and spread risk for life insurers, liquidity for non-life, funding and duration gap for banks.
Check the sign: falling yields raise both assets and liabilities, and the bigger money duration wins.

Liability-Driven Investing Basics: frequently asked questions

What is liability-driven investing in simple terms?

It is investing so that assets can pay known future obligations. You design the portfolio around the liabilities and manage the surplus, not just asset returns.

What is the difference between asset-only and liability-relative approaches?

Asset-only ignores liabilities and optimises asset return against asset risk. Liability-relative measures success against liabilities and manages surplus risk, usually with a hedging portfolio and a return-seeking portfolio.

Why do DB pension plans use long-duration bonds?

Pension liabilities are long-dated and their present value is very sensitive to interest rates. Long-duration bonds move in the same direction as the liabilities, which reduces surplus volatility.

How do bank liabilities differ from pension liabilities?

Bank liabilities are mainly deposits and borrowings that are short and can be withdrawn. The bank must manage liquidity and the duration gap between assets and liabilities, not a long stream of benefit payments.