Corporate defined benefit plan sponsors had a great year in 2013. Pension discount rates rose by almost 100 basis points (bps) and the S&P 500 rallied 32%. These tailwinds resulted in substantial gains in plans’ funding ratios of assets to liabilities, with the Milliman 100 Pension Funding Index showing an increase of 11 percentage points for the average plan. Many pension plans have a preset “glide path” program for de-risking after improvements in funded status. The asymmetric trade-off between the potential reward for taking risk in a pension plan and the health of its funding ratio provides a strong incentive to implement these plans. U.S. pension regulations require sponsors to make up underfunding over a handful of years, whereas any funds in excess of the funding requirement are not easily available for productive use by the sponsor.

Glide paths typically prescribe long- and intermediate-duration corporate bonds as the liability-matching asset because corporate bond yield curves determine discount rates used to calculate the present value of pension liabilities. As a result, current historically low corporate bond yields present a dilemma for most pension plan sponsors. While corporate bonds represent the appropriate de-risking instrument, they may appear expensive in a historical context. It is worth noting, however, that although the absolute level of yields is low, long-duration corporate bonds may not be expensive relative to Treasuries given current spread levels in comparison with levels seen in the past 20 years.

Part of the concern over bond valuations stems from the experimental policymaking of the Federal Reserve and other central banks. For example, from a purely tactical perspective, sponsors may fear that “tapering,” or the reduction in current quantitative easing measures, will result in rising rates and potentially, as we saw in May and June 2013, widening spreads. Our view is that it is reasonable to expect the Treasury curve to steepen because of reduced purchases and overall improvement in economic conditions, especially after a meaningful flattening in the long end of the yield curve since the end of 2013.

Therefore, it may not be irrational for plan sponsors to feel hesitant in taking the next step in de-risking. While the decision not to de-risk represents an active choice to speculate on the direction of interest rates, the current low levels of yields create expectations of asymmetrical outcomes. In other words, interest rates have more room to rise than fall from here.

Breaking down de-risking
The asset allocation shifts occurring at each specific node on a de-risking glide path actually include two distinct steps:

1. Reducing overall market risk through the sale of equities or other return-seeking assets

2. Investing the proceeds in a liability-matching asset (often long-dated corporate bonds)

Plan sponsors who fear rising rates may be tempted to delay the implementation of the glide path to limit their exposure to long-duration bonds. While such a decision may indeed offer a degree of risk mitigation against the impact of rising interest rates, it also entails an active decision to overweight equities or other return-seeking assets relative to the glide path’s target allocation.

Sponsors with these concerns, however, might consider staggering these moves. If the decision to delay the glide path execution stems from a concern over the potential for rising rates, plan sponsors may want to lock in recent funding ratio gains from strong equity market performance by implementing step 1 and delaying only the shift into liability-matching bonds (step 2).

It is especially important to revisit the equity allocation after strong market rallies. That is because, as the plan’s funding ratio improves, the dollar exposure to equities relative to the size of liabilities goes up (assuming a static asset allocation). For example, a plan with a 50% allocation to equities has $40 of equities for every $100 of liabilities when it is 80% funded. If the funding ratio increases to 100%, the same plan now has $50 of equities for every $100 of liabilities (a 25% increase relative to liabilities).

Ultimately, the plan’s equity risk exposure goes up as its funding ratio improves. As Figure 2 shows, the overall surplus volatility may go down as the funding ratio gets better (assuming a static asset allocation), but the contribution of equities to overall risk actually increases (see the blue portion of the bars).


The inherent increase in equity risk exposure that comes with better funded status partly explains the patterns observed in corporate plan funding ratios over the last two decades. As shown in Figure 3, it has taken about five years for funding ratios to go from trough to peak in periods of good market performance but only 18–24 months to reverse these gains.


De-risking in practice
Consider a hypothetical example of a pension plan with a 100% funding ratio, 50% invested in equities and 50% in long-duration fixed income, and a liability with a 12-year duration (see Figure 4). This plan would have an estimated surplus volatility of 9.8% (estimated surplus volatility is a measure of asset-liability risk that quantifies potential deviations between asset returns and liability returns).


We estimate that a 10-percentage-point shift from equities to fixed income reduces estimated surplus volatility by 2.1 percentage points (9.8% to 7.7%). To disaggregate the sources of this risk reduction, we can divide the asset allocation change into two parts: the move from equities to cash and the move from cash to long-duration fixed income.

As Figure 4 illustrates, equity reduction alone actually accomplishes approximately 75% of the planned de-risking. (Note that this is true only as a point-in-time snapshot of risk, without any regard to the overall returns of the asset portfolio. Investing in cash instead of long-duration fixed income may potentially result in lower estimated long-term returns.)

Steep curve reflects expectations
One of the challenges of trying to time a rise in interest rates is that the yield curve already incorporates expectations of future increases. In fact, the yield curve is unusually steep. If rates do not rise faster than what is implied by the yield curve, retaining assets in short-duration instruments would not necessarily result in an overall gain in the funding ratio of the plan. Should yields not rise, holding shorter-term instruments would actually result in a decline of the funding ratio as liabilities would grow faster than the assets.


Ideally, in our view, for sponsors concerned about rising interest rates, assets held back from long duration would be invested in an asset yielding a return commensurate with long credit yields but with minimal correlation to the level of interest rates and the equity market. Given the estimated correlation among main return-generating asset classes, however, absolute-return-oriented strategies – as long as the potential alpha they generate is uncorrelated with the market – may be optimal.

For example, instead of redirecting the proceeds from equity sales to cash in an effort to shield against potential rate increases, plan sponsors could invest in an actively managed absolute-return-oriented strategy designed to yield, for example, Libor 400 bps with 4% annual volatility and little structural duration or other market beta exposure.

Another option for plan sponsors who are seeking to reduce risk but are concerned about taking duration exposure would be to transition from equities to long-dated corporate bonds – as dictated by the glide path – while mitigating the incremental duration exposure with derivatives. This would enable the plan sponsor to reduce equity market risk and lock in the purchase of long-dated corporate bonds without immediately being exposed to incremental duration risk. After rates rise to a more comfortable level for the plan sponsor, derivatives positions could then be unwound to unleash the long-duration corporate bond exposure. We believe this strategy is especially appealing given that the potential supply/demand imbalance in long-dated credit markets could be exacerbated by the large number of plans pursuing glide
path strategies.

Consider de-risking in steps
For plan sponsors concerned that interest rates may rise, breaking down glide path de-risking into two steps may achieve significant risk reduction benefits and yet allow flexibility in purchasing long-duration bonds in a more tactical way. Should the plan’s glide path require it, any reduction in equity and other return-seeking assets should be implemented in short order to lock in significant recent market gains. Of course, some plan sponsors may decide to wait until they are more comfortable with the level of interest rates before proceeding to step 2 (investing assets in liability-matching bonds). If so, given the steep yield curve, in the meantime they should consider actively managed and absolute return-oriented strategies.

The Author

Rene Martel

Head of Pension Solutions in the Americas

Markus Aakko

Executive Office


Past performance is not a guarantee or a reliable indicator of future results.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Investors should consult their investment professional prior to making an investment decision.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

Glide Path is the asset allocation within a Target Date Strategy (also known as a Lifecycle or Target Maturity strategy) that adjusts over time as the participant’s age increases and their time horizon to retirement shortens. The basis of the Glide Path is to reduce the portfolio risk as the participant’s time horizon decreases. Typically, younger participants with a longer time horizon to retirement have sufficient time to recover from market losses, their investment risk level is higher, and they are able to make larger contributions (depending on various factors such as salary, savings, account balance, etc.). Generally, older participants and eligible retirees have shorter time horizons to retirement and their investment risk level declines as preserving income wealth becomes more important.

The option adjusted spread (OAS) measures the spread over a variety of possible interest rate paths. A security's OAS is the average return an investor will earn over Treasury returns, taking all possible future interest rate scenarios into account.

Total Carry refers to the assumed total return a portfolio would potentially achieve over a 3 month period provided that par rates and option adjusted spread (OAS) of each security held in the portfolio and currency exchange rates remain unchanged. This hypothetical example also assumes no defaults are held in the account for the time period calculated. PIMCO makes no representation that any account will achieve similar results and the statistical information provided as total carry in no way reflects the actual returns of any current PIMCO portfolio.

We employed a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to come up with an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.

PIMCO has historically used factor based stress analyses that estimate portfolio return sensitivity to various risk factors. Risk factors are the underlying exposures within asset classes that, we believe, justify a return premium and drive the variations in asset class returns. Asset classes are simply “carriers” of various risk factors.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays Long Term Government/Credit Index is an unmanaged index of U.S. Government or Investment Grade Credit Securities having a maturity of 10 years or more. Barclays U.S. Long Credit Index is the credit component of the Barclays US Government/Credit Index, a widely recognized index that features a blend of US Treasury, government-sponsored (US Agency and supranational), and corporate securities limited to a maturity of more than ten years. BofA Merrill Lynch U.S. Dollar 3 Month LIBOR (London Interbank Offered Rate) Index is an average interest rate, determined by the British Bankers Association, that banks charge one another for the use of short-term money (3 months) in England's Eurodollar market. The HFRI Fund Weighted Composite Index is comprised of over 2000 domestic and offshore constituent funds. All funds report assets in USD and report net of fees returns on a monthly basis. There is no Fund of Funds included in the index and each has at least $50 million under management or have been actively trading for at least twelve months. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The developed market country indices included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indices included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO. ​