LDI - A Statistical and Qualitative Review of Q1 2014 & Outlook for 2014

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Q1 2014 Commentary

Andrew Catalan, CFA

Andrew Catalan, CFA - Managing Director & Senior Portfolio Manager of the Liability Driven Investing group

Key Q1 Takeaways:

  • Economic activity weakened in Q1 as a result of one of the harshest winters on record, contributing to a rally in Treasury rates.
  • Spreads compressed despite the rally in Treasuries and ahead of significant LDI flows.
  • New mortality tables that project longer lifespans will increase pension liabilities by around 5%-10% and will also lengthen plan durations once effective.
  • Our expectation is that economic activity will pick up with the spring thaw, resulting in higher rates toward the second half of 2014.

Background

Starting off with a bit of good news, actuaries have extended our expected lifespan by a few years. The bad news of course is that this adjustment will be reflected in the new mortality tables used to calculate pension liabilities. The implication of these new assumptions is an increase in liabilities of between 5% and 10% on average depending on plan demographics. This news comes on top of a rate rally in Q1 that helped deteriorate funded status slightly from year end levels. In our Pension Fund Trends section below, we discuss the Society of Actuaries’ exposure draft of the new mortality table and projection scale, termed RP-2014 and Scale MP-2014 respectively.

A key phenomenon in Q1 both from a personal and economic perspective was the intensely cold and snowy winter in a large part of the nation. The weather is believed to have had a temporary but real impact on economic activity. Given the Fed’s focus until recently on employment to drive Fed policy, weak non-farm payroll figures in January and February contributed to the rate rally. The 10-year Treasury made a short-lived trip to 3.00% in December before rallying back to the 2.60% to 2.80% range. The Fed’s Quantitative Easing (QE) program nonetheless is expected to continue through the end of year, with actual tightening to begin by mid-2015. Our expectation is that economic activity will pick up with the spring thaw, resulting in higher rates toward the second half of 2014.

Activity surrounding LDI was brisk in Q1, with new mandates being implemented and additional flows into existing strategies. There has been a flurry of activity around RFPs, manager searches, glide path development and the evaluation of overlay programs. What we have not seen is an en masse move into LDI that would overwhelm the availability of securities, although we expect this dynamic will become more evident as rates rise. Plan sponsors appear to share our conviction that Treasury valuations remain rich and that we may see higher rates just around the corner. We do admit however that it is difficult to see around corners.

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