The current shift in interest rate trends is a potent reminder of the importance of managing interest rate risk in a pension plan portfolio. During an extended period of generally declining interest rates that dates back almost four decades, pension plans have been faced with a number of challenges. First, as rates fall, the pension liability is discounted at a lower discount rate, which translates to a higher present obligation. Second, pension plans need to choose between reaching for higher yield with riskier assets or facing a growing ‘yield gap’ as bonds mature and are reinvested at lower yields.
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Managing interest rate risk to meet pension obligations
Keeping pace with plan obligations in a fixed income portfolio
Source data: Macrotrends
10 year treasury rate — 54 year historical chart
Displays the daily 10 year treasury yield back to 1962. The 10 year treasury is the benchmark used to decide mortgage rates across the U.S. and is the most liquid and widely traded bond in the world.
Now that the rate environment appears to be changing, new challenges are appearing for pension plans. Rising rates have the potential to put fixed income principal at risk. In some plans, longer durations may have been a strategy used to try to maximize income generated from bond investments. In a rising rate environment, pension plans need to be mindful of duration and how it could contribute to the level of risk in the portfolio. For example, a bond with a five-year duration sees its principal value drop by 5 percent when interest rates increase by 1 percent; the negative impact grows as duration increases. With the 10-year Treasury at multi-year highs, this concern is becoming more real by the day.
Fortunately, this is one of the areas that can be addressed using customized LDI, with proper adjustments made to respond to the condition of the plan and market realities.
Recognizing the challenge
Utilizing effective strategies to manage interest rate risk is critical, regardless of the plan's funded status. For underfunded plans, typical LDI asset allocation demands a larger equity exposure to help close the funding gap. Unfortunately, this can leave the plan more exposed to interest rate risk. A combination of interest rate derivatives and risk-managed equity can be employed to immunize some of the liability interest rate sensitivity while prudently growing the plan's asset base through less volatile equity exposure. As a plan's funded status improves, more of its assets should be shifted to standard bonds, which provide both interest rate exposure and cash flow matching. Ultimately, when a plan becomes fully funded, growth assets should comprise a smaller part of its portfolio; the majority of assets should be in high-quality corporate bonds and Treasurys, with high quality structured fixed income to meet near-term cash flows. This dynamic LDI approach can help underfunded plans improve their situation, and help fully funded plans protect the gains achieved over the last decade.
Plan characteristics may have as much impact on funded status as the interest rate environment. Issues to consider include whether it is an open or closed plan, and the numbers of active participants, term vested participants and retirees in the plan. Plans must be cognizant of how longevity risks impact funding status. Only by transferring pension risk can these factors be mitigated. Short of that step, it is vital that such concerns be accounted for in the plan’s asset management strategy.
Hypothetical example used for illustrative purposes only. Not representative of any actual pension plan.
Depending on the mix of active participants and retirees, a plan’s cash flow profile changes. It is critical to customize each plan’s specific investments to minimize funded status volatility.
Our top priority? Success for your plan
Securian Asset Management Inc. (Securian AM) has more than 125 years of experience managing interest rate risk, and matching cash flows for its parent, a large insurance company. You can leverage our investment experience and expertise to help your plan. Securian AM helps your plan deliver on its promises:
- Tailored solutions — a flexible suite of institutional investments allows you to adapt our strategies with your changing needs to create long-term solutions.
- Collaborative approach — understanding your unique goals and helping you find the right path forward means being accessible, thoughtful and collaborative.
- Experienced team — in today’s fast-changing and increasingly complex market, our experienced professionals can make a significant difference in achieving key plan objectives.
Contact us to find out more about our customized dynamic liability-driven investing and how it can be applied to help pension plan sponsors meet specific objectives.
The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, Securian Asset Management, Inc. (Securian AM) does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and Securian AM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated.
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