Corporate pension plan sponsors have seen increased volatility in funded status in recent years. While equity markets have contributed to some of the volatility, declining interest rates that increased the value of liabilities have been a key driver of funded status reductions.
Among other factors, plan sponsors may have experienced different degrees of volatility depending on the structure of the fixed income investments. In the current interest rate environment, we often hear recurring questions regarding fixed income and want to share what we have found helpful in managing pension plan outcomes.
1) Does long bond investing make sense today?
Yes, long bonds are still the preferred investment for pension fixed income investments. Pension liabilities behave like bond investments, whereby the value of the liability represents the present value of future payments to participants at current yields. As illustrated in the chart below, future payments for a pension are spread out across the maturity spectrum, with a large portion of the interest rate risk (86% in the example in the chart) at the longer end of the yield curve for an average pension plan. Holding short duration bonds, such as those benchmarked to the Bloomberg Barclays US Aggregate Bond Index and that have maturities below 10 years, means that most of the plan’s interest rate risk remains unaddressed.
Source: PNC / View accessible version of this chart.
Projected Benefit Payments for a Hypothetical Plan. The above projections are hypothetical in nature, do not reflect actual plan results, and should not be relied upon for any purpose.
Some plan sponsors have inquired whether an expected rise in interest rate supports the view that fixed income duration should be shorter than the plan liability. The concern is that long duration bonds will lose value, and some of that loss could be avoided in a rising interest rate environment by holding short bonds.
Consider that interest rates can have three potential paths – they could go up, remain level or range bound, or go down. While it is difficult to predict the expected path of rates, any one of these paths is possible.
For a short duration position to benefit a plan, interest rates will have to not only increase but also increase at a faster pace or by a larger magnitude than what the market has already priced into the yield curve. That is a predicted path that many plan sponsors are not willing to accept given the complexity of the factors that drive interest rates. For this reason, and given the potential funded ratio drag that a short duration portfolio can create, we still believe long duration bonds represent the appropriate fixed income investment for a pension plan, even in the current low interest rate environment.
2) How important is active management?
In our view, it is important to keep allocations to fixed income actively managed. Passive implementation in this particular asset class is traditionally inefficient. Most pension plan long duration portfolios primarily consist of corporate credit due to pension liabilities being based on high quality corporate bond yields. The impact of bond defaults and downgrades could create a drag on pension-funded positions if not managed appropriately. When a corporate bond gets downgraded, the portfolio value decreases, which is magnified if the fund manager sells the bond at a loss after the downgrade. However, liabilities may increase if that bond drops out of the higher quality yield curve used to measure liabilities. To avoid excessive drops in funded status (from lower assets and higher liabilities), utilizing active management with a manager experienced in selling bonds before they are downgraded and navigating a volatile fixed income market is important.
3) Is there a need to customize to the plan’s liabilities?
Customization of the fixed income portfolio to the plan’s liabilities is a best practice, in our view. A fully customized solution manages the fixed income portfolio with consideration of the plan’s exposure along the entire yield curve. Going back to the chart that shows risk exposures (duration) for a sample pension plan, buying a long bond fund that has an approximate duration equal to the liability (i.e., 13.5 years in the example) does not produce the same effect as a fully customized fixed income account that matches exposure across the yield curve. This is particularly important in a volatile interest rate environment.
Long bond funds that are benchmarked to standard market indices look at the performance of bonds with maturities longer than 10 years, while the pension liabilities are dispersed more broadly with payments due much sooner. As a result, even if the bond fund duration matches the pension plan duration in total, there is a risk of funded status losses as we see changes in the shape of the yield curve (e.g., short rates move at a different pace than long rates). By having a fully customized portfolio, the performance of the fixed income investments can be aligned with the expectations of the plan sponsor. We recommend having this customization even with smaller fixed income allocations to allow the fixed income portfolio to better serve its purpose of reducing funded status risk.
Building a custom portfolio today at lower fixed income allocation levels builds the foundation for a robust and well-constructed hedging portfolio when a plan is closer to being fully funded and predominantly invested in liability hedging assets.
Managing overall pension funded status risk considers more than just interest rate risk in plan liabilities, as equity risk could be a large component of the plan risk as well. For plan sponsors looking to improve funded status, we recommend taking risk in areas where you can be rewarded with outperformance in the return-seeking portion of the portfolio. We generally recommend avoiding interest rate risk to the extent possible by following the practices described above.
Accessible Version of Chart
|Years 1-10||Years 10-20||Years 20+||Total|
|Duration||1.8 Years||4.7 Years||7.0 Years||13.5 Years|