For a long time, a rise in interest rates has been discussed and expected. While the Federal Reserve has finally begun its move away from its near-zero interest rate policy and a further rise in rates may now seem imminent, the past few years have for some sponsors underscored the fact that “being early” can prove expensive. Plan sponsors who want to prepare for higher rates should not pick strategies that are too sensitive to the precise timing of a rise in rates.
There’s another complication, which will be our focus. Rates can rise for different reasons. And, depending on the scenario in which there’s a rise in liability discount rates (determined by yields on high-grade corporate bonds), asset prices can behave very differently.
With that in mind, a better way to frame the question of what to do when rates rise is to ask: What might the future look like, and what does that mean for the plan’s investment strategy? Because the future is unknown, it seems sensible to look at different scenarios and test whether an LDI strategy is robust across these different scenarios.
Scenario Analysis Helps to Design and Validate Robust Strategies
But how can sponsors come up with plausible scenarios? Typical approaches include using historical data, reverse engineering a worst-case scenario, and generating forward-looking scenarios from economic and market analyses. To this we could also add Monte Carlo analysis — which considers tens or hundreds of thousands of random scenarios and takes statistical averages of the outcomes.
We find all these approaches useful in our overall investment process. In this work, we’ll combine two of them, by using Monte Carlo analysis to design efficient strategies, which are then validated against forward-looking scenarios. The four scenarios that we’ll focus on are: Global Recovery (where growth picks up outside the U.S.), Strong Growth (domestic growth), High Inflation (amid stagnant growth, comparable to 1970s stagflation) and Global Financial Crisis (in this scenario, corporate bond spreads widen so much that liability discount rates go up, as happened briefly in the most recent crisis).
There’s a lot of science involved in generating these economic scenarios. But it’s important to note there’s also a lot of art behind estimating asset class returns in each scenario.
To read the entire white paper, “LDI and the Rising Rates Riddle,” download the PDF document.