Liability-Hedging Investments Can Make a Pension Plan’s Market Value Funded Status Less Volatile

2022 was a remarkable year for investment markets

Coming out of a global pandemic, we saw interest rates increase at their fastest pace in decades, reaching levels not seen since the Great Financial Crisis. 2022 was the first year that both domestic stocks and domestic bonds posted materially negative returns: -18 percent and -13 percent, respectively, as discussed in the article, “Double Trouble: Stocks and Bonds Are Down Together in 2022.” The workhorse “60/40” portfolio had its second worst performance year on record. Only 2008 was worse.

The market value funded percentage for corporate pension plans improved

Even with these investment headwinds, many corporate pension plan sponsors saw their funded status improve materially because their liability return was worse than asset performance during the year, and most plan sponsors had only a small portion of the liability’s interest rate risk hedged.

The illustrative 60/40 pension plan investor below had liability returns of -26 percent as the discount rate increased by 225 bps during the year, while the assets lost only 16 percent.

According to our models, the probability of high-quality corporate yields ending the year where they did (given where they began the year), was less than 1 percent.

This constitutes an upside surprise from the perspective of funding for many single-employer plan sponsors.

The time is right for high-liability hedge ratios

The confluence of the following factors means that now may be an opportune time for corporate plan sponsors that have thus far been reticent to embrace high-liability hedge ratios within their investment policies to reassess their position:

• Many pension plans have frozen, closed or reduced accruals over the past decade.
• Funded status is materially better than it was 12–24 months ago for plan sponsors.
• Interest rates are currently at levels that seem closer to “normal” by historical standards (the 10-year Treasury yield ended 2022 at 3.9 percent; 30 months earlier it was 0.6 percent).

This means both of the following are true: liability-hedging investments (namely, long-duration bonds) are cheaper than they have been in years, and static absolute-return goals can be achieved with higher allocations to fixed income.

Expected rates of return for liability-hedging investments are highly correlated with the liability discount rate. Therefore we might expect liability-hedging investments to earn about 5.0 percent over the long-term, whereas 12–24 months earlier we might have expected them to earn a long-term rate of return of 2.5 percent.

Pension plans that embrace higher allocations to long-duration fixed income can dramatically reduce the volatility of their funded status position (or “surplus/deficit volatility”). This is on top of reductions to surplus volatility that have happened organically over the past 12-24 months as funded status has improved and liability duration has decreased with increasing yields.

The following graph shows the distribution of funded status outcomes for two different pension plan investment strategies.

The first strategy has 40 percent of assets allocated to core fixed income. So we might say they have -30 percent liability hedge ratio (the ratio of the plan asset dollar duration to the plan liability dollar duration, meaning, roughly, the change we would expect in the asset or liabilities following a 100 bps change in interest rates) and a 12.8 percent surplus volatility (the range for funded plan status over a one-year measurement period that we would expect with 68 percent probability. It is scaled to asset size and is analogous to the familiar asset-only volatility statistic).

The second has 60 percent of assets allocated to long-duration fixed income (so we might say they have a -60 percent liability hedge ratio and a 6.6 percent surplus volatility). The reduction in probability in downside funded ratios is substantial. The probability of funded status falling below 80 percent is reduced from about 16 percent to 4 percent).

A glide-path approach to reducing surplus volatility

Even if an immediate reduction to surplus volatility is , perhaps either because the plan isn’t well-funded enough or because they have too much capital tied up in private market investments that can’t easily be redeployed, it is worth considering the efficacy of a dynamic asset allocation that commits to reduced surplus volatility (by increasing the liability hedge ratio) as the plan’s funded status improves. Given the asymmetry between utility of surpluses and deficits for corporate plan sponsors — especially for sponsors of frozen plans — it is almost always optimal for a corporate plan sponsor to engage with some type of dynamic asset allocation. The discipline of writing a dynamic strategy into the investment policy statement removes the inertia of setting-it-and-forgetting-it with the strategic asset allocation and forces the sponsor to monitor the funded status more often than annually to minimize the changes of missing an upside funded status surprise (and therefore an opportunity to de-risk).

Below is a sample “glide path” and an example of a quarterly asset-liability roll-forward for purposes of monitoring funded status.

Certainly, every plan’s circumstance is different, so any change to a plan’s hedging strategy should be done with consideration for its particular situation. However, the current dynamics in markets make it worth a look.

This article is concerned with monitoring and hedging a plan’s market value funded status (for instance, the funded status shown for financial reporting purposes), and does not consider the performance of, or impact on, funded status for purposes of minimum required contributions.