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LDI (Liability-Driven Investing)

Model your future retirement spending as a series of liabilities, then build a portfolio whose duration and cash flows are designed to meet those obligations — the same approach used by pension funds.

How It Works​

Liability-Driven Investing flips the traditional retirement portfolio question. Instead of asking "how much can I safely withdraw from this portfolio?", LDI asks "what portfolio do I need to build to fund these specific future payments?" It is the approach used by corporate pension funds and insurance companies that must meet defined future obligations, adapted for individual retirees.

The process starts by mapping out your future spending needs year by year. Each year's projected spending becomes a "liability" — an obligation you need to fund. LDI then constructs a portfolio whose assets are specifically chosen to match those liabilities in terms of timing, amount, and sensitivity to interest rates (duration matching).

The matching portfolio typically consists of high-quality bonds with maturities aligned to each year's spending need. Any remaining assets beyond what's needed to fund the liabilities go into a "surplus portfolio" invested for growth. The critical discipline is that the matching portfolio is managed purely to meet obligations — not to maximize returns. This separation ensures that your essential spending is funded regardless of what happens in equity markets, while the surplus portfolio provides upside for discretionary spending, legacy, and extending the plan.

The Formula​

Step 1 — Map liabilities:

For each year Y from 1 to planning_horizon:
    liability[Y] = projected_spending[Y] (inflation-adjusted)

Step 2 — Build matching portfolio:

For each liability[Y]:
    Purchase fixed-income asset with:
        maturity = Y years
        face_value >= liability[Y]
        duration matched to liability timing

matching_portfolio = sum of all purchased assets

Step 3 — Allocate surplus:

surplus_portfolio = total_portfolio - matching_portfolio_cost
    → Invested in growth assets (equities, alternatives)

Each year:

withdrawal = maturing asset from matching portfolio (funded with certainty)
surplus_portfolio grows for discretionary spending and plan extension

Key parameters:

  • Liability schedule: Year-by-year projected spending (inflation-adjusted)
  • Duration matching: Aligning asset durations to liability timing
  • Funding ratio: Matching portfolio value / present value of liabilities (target: 100%+)
  • Surplus allocation: How to invest assets beyond what's needed for liabilities

Pros & Cons​

Advantages:

  • Funding certainty — essential spending obligations are matched with dedicated assets
  • Duration matching immunizes the plan against interest rate changes
  • Pension-grade methodology backed by decades of institutional practice
  • Clear separation between "must-fund" and "nice-to-have" spending

Limitations:

  • Lower growth potential — matching portfolio is locked in fixed income
  • Complex to implement — requires precise liability mapping and duration calculations
  • Demands accurate spending projections, which are inherently uncertain for individuals
  • Requires ongoing monitoring to maintain the match as conditions change

Example​

Starting portfolio: $1,000,000 | Annual essential spending: $40,000 | Discretionary: $15,000 | Planning horizon: 25 years

Liability map: $40,000/year essential spending for 25 years = $1,000,000 nominal (less in present value due to discounting)

At a 3% discount rate:

  • Present value of essential liabilities: ~$700,000
  • Matching portfolio: $700,000 in duration-matched bonds/TIPS
  • Surplus portfolio: $300,000 in equities
YearMatching Portfolio PaysSurplus PortfolioDiscretionary DrawTotal Income
1$40,000$300,000$12,000$52,000
5$40,000$360,000$14,400$54,400
10$40,000$450,000$18,000$58,000
15$40,000$520,000$20,800$60,800
20$40,000$550,000$22,000$62,000
25$40,000$560,000—$40,000

Essential spending ($40,000) is guaranteed every year by the matching portfolio. Discretionary spending comes from the surplus and can flex with market conditions. Even if equities crash, the essential spending is untouched.

When to Use This Method​

LDI works best for retirees who:

  • Have clearly defined essential vs. discretionary spending and want certainty on the essentials
  • Have a large enough portfolio to fund the matching portfolio and still have a meaningful surplus
  • Are comfortable with institutional-grade planning and periodic rebalancing
  • Want the highest possible confidence that they won't run short on basic living expenses

It is less suitable for retirees with smaller portfolios (where funding liabilities consumes everything), those who prefer simplicity, or anyone whose spending needs are too uncertain to project reliably.

Try It Yourself

Compare LDI against other strategies using your own numbers in the Scenario Builder.

References​