Learning Outcomes
After reading this article, you will be able to explain the key differences and connections between liability-driven investing (LDI) and goal-based investing (GBI) for private and institutional clients. You will become proficient in the principles of goal hierarchy, the design and rationale of multi-bucket portfolios, and the behavioral and risk management factors driving these strategies. You will be able to apply goal structuring and multi-bucket frameworks to address both institutional liabilities and individual financial goals.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand both the theory and practical application of liability-driven and goal-based approaches in constructing, monitoring, and revising portfolios. In particular, your knowledge should cover:
- Recognizing and comparing liability-driven and goal-based investing objectives
- Describing and explaining goal hierarchy and its relevance for individual investors and institutions
- Designing and evaluating multi-bucket portfolio structures for different types of liabilities or goals
- Integrating behavioral, time horizon, and risk tolerance considerations into goal prioritization and portfolio construction
- Applying bucket and hierarchy structures to both DB pension funds and private wealth clients
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the key distinction between a liability-driven and a goal-based approach to portfolio construction?
- In private wealth, how might you structure a portfolio to fund basic needs versus aspirational goals?
- Explain what is meant by a multi-bucket portfolio and how it relates to time horizon and goal risk level.
- Identify one behavioral bias that may influence the construction of goal hierarchies for individual investors.
Introduction
Portfolio construction can be organized around two mutually reinforcing approaches: liability-driven investing (LDI) and goal-based investing (GBI). These methods structure asset allocation with explicit reference to future financial obligations—either through contractual liabilities for institutions or personal financial goals for individuals. Hierarchies of goals and multi-bucket portfolios allow investors and their advisers to better match asset risk to specific needs and timeframes, accommodate behavioral biases, and improve portfolio adherence in volatile markets.
Key Term: Liability-driven investing (LDI)
An investment approach that focuses asset allocation and risk management on meeting future defined liabilities, typically by matching asset cash flows and risk attributes to the size, timing, and nature of those obligations.Key Term: Goal-based investing (GBI)
A strategy that segments an individual’s or institution’s portfolio into sub-portfolios ("buckets"), each dedicated to meeting a specific financial goal or set of goals, with investment risk tailored to the importance and time horizon of each goal.Key Term: Goal hierarchy
The process of ranking objectives or liabilities by priority, urgency, and required probability of success, so that portfolio resources and risk levels are adjusted accordingly.Key Term: Multi-bucket portfolio
A structure in which portfolio assets are divided into distinct "buckets," each with its own risk/return profile and funding a specific goal, liability, or time period.
Liability-driven and Goal-based Approaches: What Are They?
Liability-driven and goal-based frameworks share a focus on structuring portfolios around future outflows. Both recognize that investors—whether pension plans or individuals—will benefit from having distinct asset pools (or "buckets") matched to the nature and timing of their required cash flows.
Liability-driven Investing: Institutional Focus
Liability-driven investing is most commonly associated with institutions like defined benefit pension funds or insurers. For these entities, the relevant future outflows are contractual and well-defined: pension payments, annuity streams, or insurance claims.
LDI strategies usually follow one or more of these principles:
- Hedging the present value and risk exposures of liabilities with dedicated asset portfolios
- Matching the duration, currency, and inflation sensitivity of assets to those of liabilities ("immunization")
- Prioritizing certainty of outcome and minimization of shortfall risk over pure return maximization
LDI can also apply to high-net-worth individuals with contractually required outflows (e.g., debt repayments).
Goal-based Investing: The Private Wealth Viewpoint
Goal-based investing segments an investor’s portfolio according to different personal objectives—retirement security, education, legacy, philanthropy, luxury purchases, and more. Each goal is distinct in importance, required time horizon, and desired probability of success.
GBI uses the concept of goal hierarchy: critical or near-term goals (such as lifetime spending needs) are ranked above less essential or longer-term aspirational goals (such as leaving a large bequest or purchasing a second home). The portfolio is divided into "buckets"—each with tailored investments to maximize the chance of success for its goal.
Unlike LDI, GBI often incorporates behavioral biases and recognizes that individual goals may change over time or compete for resources.
Building Goal Hierarchies: From Needs to Aspirations
The concept of a goal hierarchy is central to both LDI and GBI but takes a particularly practical form in private wealth.
Clients’ goals can be categorized, for example, as:
- Essential (basic needs): Retirement income to fund living expenses
- Important (lifestyle/extras): Private education for children, travel fund, home upgrades
- Aspirational: Large bequests, major charitable donations, funding multiple generations
A goal hierarchy sets the order of funding and assigns required probabilities of success (e.g., 99% for essentials, 75% for aspirations).
Key Term: Probability of goal achievement
The likelihood that a specific asset allocation will allow the investor to meet a defined financial objective without shortfall.
Multi-bucket Portfolios: Segmenting Money with a Purpose
A multi-bucket portfolio divides client assets into distinct sub-portfolios ("buckets"), mapped to the specific goals and timeframes identified in the goal hierarchy.
Common segmentation might include:
- Safety bucket: Low-risk assets to fund essential, near-term living expenses
- Lifestyle bucket: Moderately risky assets supporting important but non-essential goals with a medium-term horizon
- Aspirational bucket: Long-term, higher-risk investments targeting discretionary or legacy objectives
This structure enables a clear mapping between portfolio assets and client priorities.
Worked Example 1.1
Question: A retiree has $3,000,000 to fund her needs, desires $30,000 per year for basic living expenses (20-year horizon), $10,000 per year for travel (next 10 years), and hopes to leave a $1,000,000 bequest. How might a multi-bucket portfolio be constructed to support her goal hierarchy?
Answer:
- Bucket 1 (Essentials): Allocate enough to secure $30,000 annual living expenses for 20 years, using low-risk fixed income to maximize certainty (highest required probability of success).
- Bucket 2 (Important): Allocate a portion for travel, invested in a balanced portfolio with moderate volatility (medium probability of success).
- Bucket 3 (Aspirational): Place the remainder in equity-oriented assets designed for long-term growth, accepting more risk of underperformance (lower required probability of success).
Key Steps in Goal-based and Multi-bucket Portfolio Construction
When designing a goal-based or multi-bucket portfolio, follow these steps:
- Identify and categorize all financial goals: Specify each objective and its time horizon.
- Rank and assign probabilities: Classify goals by importance and assign the minimum acceptable probability of achieving each.
- Determine required assets: For each bucket, calculate the present value of assets needed to meet its funding level at the assigned probability.
- Select asset allocation: Choose an investment mix for each bucket based on time horizon and acceptable risk.
- Implement and monitor: Allocate assets accordingly, and periodically review as goals, risk tolerance, or markets change.
Key Term: Bucket approach
The practice of dividing assets into separate pools, each matched to specific liabilities or goals, with distinct risk/return profiles.
Behavioral and Practical Considerations
Behavioral biases affect goal prioritization and adherence to planned allocations. Common examples include:
- Mental accounting: Investors unconsciously segment their money into separate "accounts" for different purposes, which may facilitate adherence to buckets.
- Loss aversion: Clients may designate more assets to essential buckets than mathematically necessary because shortfalls in basic needs are intolerable.
- Hyperbolic discounting: Clients may underweight long-term goals compared to short-term consumption.
Accommodating these tendencies within the goal hierarchy and multi-bucket approach can improve engagement and prevent panic-driven reallocation in times of stress.
Worked Example 1.2
Question: An individual is worried about market volatility eroding essential retirement income. How can a multi-bucket approach address this behavioral concern?
Answer:
By allocating a "safety bucket" to low-volatility, short-duration assets that are largely immune to market swings and solely dedicated to funding basic needs, the investor gains confidence that essential spending is protected, reducing the fear-driven temptation to sell higher-risk assets in adverse markets.
Exam Warning
In the exam, do not assume that all buckets must hold risk-free assets. The appropriate risk level and investment horizon should be matched to the specific goal, with higher-risk allocations reserved for lower-priority or long-term goals. Mislabeling aspirational goal buckets as needing high certainty is a common mistake.
Applying Buckets and Hierarchies: Institutional and Private Contexts
- Institutional LDI: Defined benefit pension plans may use two buckets: a hedging portfolio (matching bonds, swaps) for contractual liabilities, and a return-seeking portfolio (growth assets) to improve surplus or lower sponsor contributions.
- Private GBI: Individuals with multiple financial objectives can benefit from buckets mapped to their own goal priority, including essential spending, lifestyle needs, and legacy aspirations.
Summary
A liability-driven or goal-based framework uses explicit goal hierarchies and bucketed portfolios to closely align asset allocation with the timing, importance, and risk tolerance of specific financial objectives. This approach is applicable to both institutions with known liabilities and individuals with prioritized goals. The bucket strategy improves risk management, behavioral adherence, and communication between adviser and client, supporting higher odds of meeting essential financial needs.
Key Point Checklist
This article has covered the following key knowledge points:
- Liability-driven investing aligns portfolios to future defined liabilities or goals
- Goal hierarchies prioritize objectives by urgency and required confidence level
- Multi-bucket portfolios segregate assets into sub-portfolios matched to goal timing and risk
- Essential goals receive higher probability and lower risk allocation; aspirational goals accept more risk
- Behavioral biases impact goal prioritization and can be addressed in bucket design
- Both institutional (e.g., pensions) and private client portfolios use these structures
Key Terms and Concepts
- Liability-driven investing (LDI)
- Goal-based investing (GBI)
- Goal hierarchy
- Multi-bucket portfolio
- Probability of goal achievement
- Bucket approach