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
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
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.