One of the first steps plan sponsors take to help reduce pension funded status risk is to extend the duration of their fixed income investments, that is, moving from short maturity bonds to long maturity bonds. Many organizations have embraced this step, but it seems there are some that are waiting for higher interest rate environments to make this change.
Many of those waiting cite the concern that if rates rise, their long duration portfolios will lose value.
We have highlighted a few key points for plan sponsors to consider when seeking to validate their decisions on the structure of their fixed income investments.
Background: Manageable Risks
Managing pension funded status risk allows the sponsor to help manage contributions, administrative costs, and balance sheet risks related to the pension. There are two primary risks affecting funded status that can be managed with plan investments:
- Equity risk, which represents volatility in funded status due to large swings in equity values. Having some equity risk is generally acceptable to plans sponsors because equities are expected to offer higher returns.
- Interest rate risk, which represents volatility in funded status due to the mismatch between assets’ and liabilities’ interest rate exposure (that is, duration). Pension liabilities behave like bond investments, whereby the value of the liability represents the present value of future payments to participants at current yields. Therefore, interest rate risk exists for a pension plan even if it doesn’t hold any fixed income investments.
The investments that help minimize funded status risk are long-duration bonds that behave like the plan liabilities.
With liability duration being a key measure of interest rate risk, most of a plan’s interest rate risk lies in the longer end of the yield curve for an average pension plan.
Holding short-duration bonds, such as those benchmarked to the aggregate bond index and which have maturities below 10 years, means that most of the plan’s interest rate risk remains unaddressed.
Why Extend Duration
Even in a rising interest rate environment, there are still a number of arguments for maintaining a portfolio with longer-duration bonds that are liability matched versus shorter-duration bonds:
- Interest rate risk is not compensated. Equity risk is considered a compensated risk because returns are expected to be above and beyond any increase in liabilities. However, interest rate risk is viewed as an uncompensated risk since short-duration bonds do not provide excess returns relative to liabilities.
- Minimize funded status volatility. By extending the duration of the fixed income investments to mirror the liabilities, the plan may have some assets that move in tandem with the liabilities as interest rates fluctuate. This means overall funded status will be less variable; for example, if liabilities increase due to lower rates, the bond investments would increase by a similar magnitude.
- Waiting for rates is costly. Liabilities grow with interest due to bond-like features (that is, if the discount rate is 4%, expect liabilities to grow 4% annually, all else equal). Holding on to short-duration bonds means the fixed income portfolio is expected to earn yields less than its longer-duration counterparts and ultimately less than the growth in liabilities. Therefore, waiting for rates to rise before extending duration comes at a cost to the plan. This creates a drag on the funded status that would need to be filled by the return from other investments or by additional contributions.
- Long rates are more unpredictable. There is an expectation that short-term rates will rise as the Federal Reserve (Fed) continues to increase the federal funds rate. Yields on short-duration bonds are highly correlated with the federal funds rate. This means that shorter-duration bonds are likely to decline in value when the Fed increases the rate (bond price is inversely correlated with yield). But what the Fed does on the short end has little impact on long rates that drive pension liabilities. With changes in long rates driven more by fundamental changes in the economy, long portfolios may perform better than short portfolios if the yield curve continues to flatten. We observed this in 2017 when the Fed raised rates three times and yet long bonds provided double-digit returns.
Consider Extending Duration
In our view, there is only one solid reason for holding on to short-duration bonds in the fixed income portfolio today.
Specifically, the plan sponsor must believe that interest rates will rise at a faster pace or by a larger magnitude than what the market has already priced into the yield curve.
This, in our opinion, is the only way holding a short-duration portfolio will result in a better funded position than long-duration investments in today’s interest rate environment.