Pension plan sponsors are trying to determine where and how to begin de-risking their pension plans. Typically there are five major market risks embedded in a defined benefit pension plan:
Interest rate risk: A result of a pension plan’s liabilities being more sensitive to changes in interest rates than the plan’s assets.
Inflation risk: The risk that actual inflation rises faster than assumed.
Equity market risk: The risk that equity market returns are below expectations.
F/X risk: The risk that currency fluctuations erode returns on investments made outside of Canada.
Longevity risk: The risk that plan members live longer than expected.
Typically interest rate and equity market risks represent 80% of the total risk in a non-indexed pension plan.
We believe that reducing interest rate risk is the first step in the de-risking process since it represents a large portion of the total risk in a pension plan.
There are three approaches to reducing the amount of interest rate risk in a pension plan:
- Extending the duration of the fixed income portfolio: This typically involves moving from a universe bond mandate to a long bond mandate.
- Increasing the overall allocation to fixed income: Increasing the allocation to fixed income needs to be balanced with the plan’s ability to afford purchasing fixed income securities at current prices.
- Bond overlay strategies: This approach uses derivative instruments to synthetically create a fixed income portfolio. Plan sponsors would implement a bond overlay strategy if they wish to reduce their interest rate risk exposure and believe that other asset classes will outperform fixed income securities.
Many plan sponsors would probably be surprised by the fact we are recommending pension plans to increase the duration of their fixed income portfolio since the consensus view is that interest rates are going to rise. We believe that increasing the duration of the fixed income portfolio provides pension plan’s better downside risk protection in case interest rates decrease while still allowing for the funded status of the plan to benefit if interest rates rise. Interest rates can move in 3 directions from current levels: (i) increase; (ii) no change; and (iii) decrease.
Interest rates increase
If interest rates increase, the funded status of a pension plan would improve since the plan’s liabilities would decrease by a larger amount than the fixed income portfolio. The funded status would improve because 100% of the liabilities would benefit from a rise in interest rates while only 40% of the assets (i.e. the fixed income portfolio) would be impacted by increasing rates. In a rising interest rate environment a shorter duration bond portfolio would outperform a longer duration bond portfolio but the overall impact on the funded status wouldn’t be significant since in both cases (short or long fixed income duration) the funded status of the plan would improve.
No change in interest rates
If interest rates do not change from current levels, extending the duration of the fixed income portfolio would typically result in a 1.2% to 1.5% increase in return on the fixed income portfolio since longer duration bonds typically have higher yields than shorter duration bonds.
Interest rates decrease
If interest rates decrease, the funded status of a pension plan would deteriorate since the plan’s liabilities would increase by a larger amount than the fixed income portfolio. The funded status would deteriorate because 100% of the liabilities would be negatively impacted from a decrease in interest rates while only 40% of the assets (i.e. the fixed income portfolio) would be impacted by decreasing rates. By extending the duration of the fixed income portfolio the magnitude of the increase in deficit would be smaller.
In our opinion, if interest rates were to dramatically decline from current levels it would likely mean that the global economy has gone back into a recession or into a deflationary environment. If this were to happen, it is likely that equity markets would have disappointing returns which means we would be entering into another “Perfect Pension Storm”: Declining equity markets, declining interest rates and a tough business environment. Extending the duration of the fixed income portfolio will help mitigate the financial impact to plan sponsors in a “Perfect Pension Storm” environment without sacrificing much of the benefits in a rising interest rate environment.
Soami Kohly is vice-president, McLean Budden.