Moving Beyond Duration Hedging

It’s time for pensions to tackle the next steps in pension risk management.

Pension de-risking plans, or glide paths, typically focus on two risks: interest rate risk and credit spread risk. Unfortunately, other risks in a pension plan’s portfolio can quickly overwhelm these two risks limiting the effectiveness of many hedging programs. The next step in pension risk management is to establish short-term surplus volatility targets, and incorporate risk assets into the hedging program for a truly integrated approach to risk-management. Exhibit 1 illustrates the change in surplus volatility, defined as the tracking error between asset and liability returns, at differing funded ratio levels and asset allocations. Higher allocations to risk assets (e.g., equities, commodities), as opposed to a liability-matched fixed income strategy, lead to a substantial increase in surplus volatility. Furthermore, as funded ratios decline, surplus volatility increases. Consequently, underfunded plans and those with even modest allocations to risk assets will experience significant surplus volatility. For example, a plan that is 90% funded and has 60% of its assets invested in risk assets will exhibit surplus volatility of 11.5% annualized. An additional complication is that surplus volatility levels for most pension plans are far from stable. Exhibit 1 is based on durations, volatility levels, and correlations at one point in time. However, all of these factors can change quickly over short periods of time, causing surplus volatility to spike in high-volatility environments. Continuing with our previous example of a 90% funded plan with 60% of its assets invested in risk assets and the remainder in long-duration fixed income, the plan’s surplus volatility would have jumped 400% from 2007 to 2008. Plan sponsors are now moving beyond a myopic focus on interest rates and are beginning to manage risk across the plan’s total portfolio. The first step is to identify an acceptable level of surplus volatility (or funded-ratio volatility), and establish an approach that seeks to keep volatility continually at that level. This approach requires more than duration and credit spread hedging.
* Based on a set of assumptions that Nuveen Asset Management believes fairly represents the characteristics of equities, commodities, fixed income securities, and plan liabilities. Actual investor experience will differ. The views presented are the opinions of Nuveen Asset Management and are subject to change. They are not intended as investment advice or to predict or depict the performance of any investment or portfolio. This information should not be construed as providing investment, legal or tax advice. No offer or solicitation for the sale of any security or financial product or service is made hereby. Nuveen Asset Management, LLC is a registered investment adviser and affiliate of Nuveen Investments, Inc. Nuveen | 333 West Wacker Drive | Chicago, IL 60606 | 800.752.8700 |