Director | CAPTRUST Consulting Research Group
As a result of the Pension Protection Act of 2006, pension Plan Sponsors have aligned assets with liabilities by buying longer duration, high-quality corporate Fixed Income securities as a hedge against the impact of interest rate movement on plan liabilities. Simplistically, if interest rates go up, most asset prices will go down, but so will pension liabilities. However, pension liabilities will generally decrease by a larger magnitude since most pension plans are underfunded. Despite this, committees continue to struggle with the decision to implement liability hedging portfolios and more specifically to improve the portfolio interest rate hedge. Below are a few common misperceptions surrounding this topic for your consideration.
Misperception: Interest rates will go up and this will improve the plan’s funded ratio.
All else equal, a rising-rate environment will improve the funding situation for underfunded plans. However, there is no guarantee that interest rates will increase in the near future. In fact, the Fed is forecasting a low interest rate environment until the end of 2014 and if economic growth continues at an anemic pace in combination with high unemployment, it could be even longer. Collecting a higher yield from longer duration corporate bonds could serve to improve investment results in a sustained low-rate environment. Additionally, with forced funding rules it is possible that Plan Sponsor contributions will have a larger impact on pension funding than interest rate increases will.
Misperception: If interest rates go up and plans have a liability hedging portfolio, Plan Sponsors are essentially locking in the current underfunded status.
A fully hedged, fully funded plan will not experience a funding improvement if rates rise. However, asymmetry exists in that there is little reward for being materially overfunded while a materially underfunded plan presents quite a large risk. For underfunded plans that have perfect alignment of assets and liabilities, an interest rate increase will serve to improve funding and a rate decrease will deteriorate funding since the liabilities are larger than the assets. Additionally, most Plan Sponsors elect to maintain a shorter duration on assets (less interest rate sensitivity) than liabilities, even if they increase exposure to longer corporate bonds relative to a traditional intermediate bond strategy. Generally, this positioning will serve to improve funded status if interest rates increase.
Misperception: When interest rates increase, a long duration bond portfolio will decrease in value.
This may or may not be true as the experience will largely depend on the interest rate change’s magnitude and speed, as well as the resultant shape of the yield curve plus the interaction of spreads within the liability hedge. There are many known strategies that bond managers can utilize to offset the impact of rising rates, including diversifying within the asset class plus yield curve and duration positioning. While no guarantee of added value or harmony with the liability hedge exists, these tools are a reasonable option for Plan Sponsors seeking to mitigate the impact of rising interest rates on the asset portfolio.
We continue to support the notion that CAPTRUST Clients should only take measured risks in their portfolios while maintaining the end objective of improving funded status and most importantly acting in their participants’ best interests. As funded status improves through asset performance, interest rate movement and/or contributions, the risk of positioning portfolios based on interest rate views is amplified. While we are not suggesting that Clients avoid capital market views in implementing portfolio strategies, we do believe that for some Clients the potential risks can outweigh the benefits. As a reminder, 92% of actively managed bond portfolios in Morningstar’s Intermediate Bond Universe underperformed the Barclay’s Capital Aggregate Bond Index in 2011 and the most prevalent cause was the manager’s call on expected interest rate movement1.
1 Zephyr Analytics