The Federal Reserve has finally begun its move away from its near-zero interest rate policy, and many plan sponsors may expect interest rates to rise further. From an LDI perspective, what should you do if and when rates rise, and discount rates increase accordingly? This, it turns out, is a simple question with a far-from-simple answer. Interest rates can go up for a variety of reasons. The economic backdrops in which liability discount rates may rise can be surprisingly different and, consequently, so can the behavior of asset prices.
Of course, the future is unknown, so a sensible approach is to consider some different hypothetical scenarios and explore how an LDI strategy may fare in each one.
Here, we construct scenarios with the help of an econometric model. Then, we use Monte Carlo analysis to develop a strategy designed to be optimal according to the LDI efficient frontier, and test its performance against this range of forward-looking scenarios.
To read the entire white paper, “LDI and the Rising Rates Riddle,” download the PDF document.