Pension Risk Management in a Low Interest-Rate World

From aiCIO Magazine's 2011 Liability-Driven Investing Issue: Column by Ari Jacobs and Matthew Clink of Aon Hewitt.

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The precipitous decline in interest rates has put plan sponsors in what is becoming an all-too-familiar quandary—how do I de-risk given the high costs of doing so today? With interest rates at all-time lows, logic suggests delaying action that would extend the interest-rate duration of the portfolio while bonds are expensive. 

While yields are very low currently, a closer look reveals some opportunities. The decline in yields initially had come about by way of a flight to quality that drove down the real yield on Treasuries. Slower growth expectations have led to a decline in the level of inflation priced into the market. During the last month, this has resulted in negative real yields on 10-year TIPS and nominal yields below 2% for 10-year Treasuries. More recently, Operation Twist has pushed the long end of the yield curve lower, much to the chagrin of plan sponsors. This action has impacted the “when” but not the “if” question regarding a future rise in interest rates. If the US Federal Reserve is successful, the economy will pick up and real rates and inflation expectations will drive nominal yields higher; if they are not successful, fiscal and monetary stimulus eventually will have similar results, albeit further out in time. 

Before we address the timing issue, it would behoove us to reflect on the opportunities that do exist in the bond market today for pension plan investors. First, credit spreads have widened considerably as Treasury yields have declined. Currently, Long Credit Indices are providing spreads well above 2%. Second, bond prices have become more dispersed as spreads have increased, leading to additional opportunities for active managers to add value. And finally, the yield curve remains fairly steep, providing long-duration investors with a healthy yield carry and a positive return.

Since 2009, we have seen many plan sponsors adopt glide paths to address the following question: How do I sell equities and buy bonds in a smart way as equity prices recover? Our 2011 Aon Hewitt Global Pension Risk Survey shows that 21% of plans have already implemented a glide path strategy while another 29% are targeting this change in the next year. Using improvements in their plan’s funded ratio to guide their actions, many have sold equities and bought long-duration bonds as equity markets have rallied and bond yields have fluctuated. This one-dimensional approach worked well while bond yields hovered at reasonable levels. However, the more recent decline in bond yields has reached such a low level that even the plan sponsors on the vanguard of pension risk management have questioned whether they should continue to de-risk at this time. It is time to take the next step and adopt a two-dimensional approach. 

The second dimension is the level of interest rates, or more specifically, the level of the yield that underlies the funded-ratio metric that drives the glide path (usually a long corporate bond yield). Whereas the plan’s funded ratio should define how much risk and return needs to be targeted based on the allocation to return-seeking assets (stocks, alternatives, etc.), the level of interest rates should define how the liability-hedging assets (bonds) need to be invested. This latter dimension may be broken down into the following components: 1) target duration level, 2) yield curve positioning, and 3) the blend of government and corporate bonds.

The second dimension adds another buy-low, sell-high mechanism to the pension risk program, leading plan sponsors to the more favorably priced portions of the market as they de-risk by addressing the three items above. But this is not the primary advantage of a two-dimensional de-risking policy. Its most influential contribution is that it provides plan sponsors with a clear road map, which allows them to continue implementing their de-risking programs without having to time the increase in interest rates. As history has proven, investment committees are not well positioned to make such decisions. 

Two-dimensional investment policies may be designed by conducting an asset-liability study. It is paramount that these policies reside within the plan investment policy statement so that they may be executed seamlessly. We have found that it is helpful to change the investment committee’s governance process by focusing quarterly investment reviews on the performance of assets versus liabilities (the true plan benchmark). 

As more focus is placed on pension risk management, it has become more common for plan sponsors to outsource the execution of their dynamic investment policy to firms that specialize in investments and actuarial science. As such, bundled solutions are becoming more common—both simple and complex de-risking programs should utilize all available tools.

The balance between long-term strategies and short-term opportunities is difficult, especially in volatile environments. Defining and staying the course is most important, though one must also manage through external events like low interest rates in a thoughtful and thorough way.

Matthew Clink is the Head of Portfolio Management for the US Delegated Team of Hewitt Ennis Knupp. Ari Jacobs is a Managing Principal and Retirement Solutions Leader at Aon Hewitt.