2023 showed how seemingly minor shortcomings in a defined benefit pension plan’s portfolio can have outsized impacts. In 2023, the Treasury yield curve made dramatic shifts, turns and twists resulting in a challenging period for bond portfolios designed to mitigate the impacts of these interest rate changes. This was especially painful for some plans that were nearing plan termination as some plan sponsors were surprised that their funding level had deteriorated, even though they were supposedly fully immunized against changes in interest rates. Using a firm that specializes in closely matching assets with plan specific liabilities can help plan sponsors avoid nasty surprises.
First, some background on the interest rate hedging problem. The liabilities of every pension plan will have their own characteristics, and so will have different sensitivities to changes in the level of interest rates across the yield curve. For example, a plan with mostly retirees will have a shorter duration and a plan with a larger active participant population will be longer. The range (in the US) will typically fall between 8 and 14 years. These liabilities, for corporate accounting and annuity pricing purposes, are valued based on a full yield curve of high quality bonds.
In theory, to hedge, or “match” these liabilities, an investor can invest in a high-quality bond portfolio of the same dollar amount as the present value of liabilities, and with the same duration, or sensitivity to changes in interest rates.
However, it’s never quite that simple in practice. Many plans are underfunded, or their asset pool too small to have a custom bond portfolio built for them. Plans too small for a custom strategy are left to choose from amongst various pooled strategies offered by bond managers and then mix and match amongst those funds to achieve the desired duration. If a plan is underfunded and wishes to hedge 100% of their interest rate exposure, then it needs to extend the duration of its bond portfolio, or utilize derivatives, to account for this. For example, if a plan is 80% funded with a liability duration of 10 years, it needs to invest in a bond portfolio with a duration of 12.5 years in order to be 100% hedged (10Y/0.8 = 12.5Y).
There are many pension plans that use only pooled funds and/or are underfunded, but which are also trying to hedge a high proportion of interest rate risk. We have seen a lot of disappointment with the effectiveness of these hedging strategies for several reasons.
The yield curve can shift in a non-parallel fashion. If the assets are invested with a different duration than the liabilities at different points on the yield curve (5 years vs. 15 years, for example), than this can produce a gain or loss depending on how the curve shifts.
A pooled fund external manager invests differently than their benchmark. Many bond managers will try and predict changes in interest rates and will lengthen or shorten their portfolio duration vs. their benchmark. If constructing a liability-matching portfolio using pooled funds, these differences can lead to gains and losses and can be unpredictable.
Portfolio not monitored closely and rebalanced frequently. Maintaining an interest rate hedge ratio requires constant review and revaluation, especially if the portfolio is constructed using pooled funds or the plan is underfunded. Other changes that can happen which warrant changes are payments of lump sums (either through normal retirements or as part of a lump sum offer), or steps taken to de-risk ahead of a plan termination. Changes to liabilities mean changes should happen with the assets – there is no “set and forget” asset allocation.
As an example, we compared two portfolios since the start of 2022 through the end of 2023. Both are targeting a high hedge ratio, one is doing so with pooled funds, the other with a custom portfolio. The outcome was quite different. The custom portfolio, as measured by the liability change, had outperformed the liability returns by 3%, while the pooled portfolio trailed by almost 1%. What is even more interesting is that the management cost of the two portfolios was essentially equivalent.
Bottom line, even if you believe you are fully hedged, you may find yourself with unexpected gains and losses. It’s important, especially for plans desiring a high interest rate hedge ratio, to work with a team that is expert in these matters and is diligent about rebalancing the portfolio. We too often find plans on autopilot, believing the incumbent consultant or asset manager has complete control, only to find out that they allowed mismatches to occur that could have been prevented.
