LDI and the Rising Rates Riddle | Capital Group


LDI and the Rising Rates Riddle


What Should Plan Sponsors Do When Rates Rise?

Under What Scenarios Might Sponsors Confront Rising Discount Rates?

Source: Capital Group.

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.

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What Pension Plan Contributions Might Be Needed?

To contribute, or not? It's a big question for plan sponsors. Our experience working with sponsors suggests that it's typically optimal for them to make some contributions — especially from an after-tax perspective. What’s more, there’s good reason to think that the economics of making contributions will become still more compelling over the next few years. Underfunded plans will face a large and growing cash penalty for deferring contributions. Because the economics are swinging strongly in favor of making contributions, plan sponsors with bond market access may even have an incentive to borrow to fund the plan.

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When Rates Rise, How Might Your LDI Strategy Fare?

Forecast Yields and Fed Funds Rate

Data presented is for informational purposes only and is not intended to provide any assurance or promise of actual results. Analysis results are highly dependent on our assumptions and actual results may vary significantly because future market characteristics may not match our assumptions. All market forecasts are subject to a wide margin of error, including our own. Analysis performed using economic modeling, historical comparisons and subjective judgments. Hypothetical economic forecasts were developed using an economic model, historical data and judgment. Economic scenarios: These were specified individually in detail using a global macroeconomic model, the NiGEM model developed at the U.K. National Institute of Economic and Social Research. The NiGEM model was then used to generate five-year forecasts of various economic variables such as growth and inflation, short-and long-term interest rates, corporate earnings growth and lending spreads, and exchange rates.
Source: Capital Group.

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.

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