When considering a metaphor for pension risk, my mind immediately went to the playgrounds of my youth. You see unlike today’s ergonomic, plastic play cocoons built atop padded rubber mats, the late 20th century playground was a very risky place. Precarious ladders leading to blazing hot metal slides, centrifugal merry-go-rounds better suited for testing NASA astronauts, and rusted monkey bars bolted into slabs of solid concrete were the standard of the day.
But the see-saw was the king of risky playthings because you were at the mercy of forces beyond your control (namely, your partner and gravity). It wasn’t unusual for my co-see-sawer to bail out as they reached the ground, leaving my (now significantly heavier) end crashing to the ground.
Sounds like appropriate imagery for defined benefit (DB) sponsors battling forces beyond their control in their quest to manage risk…
Interest Rate See-Saw
Imagine a see-saw with two riders. On one side is interest rates (specifically high quality corporate bond rates), and on the other is a pension liability.
If interest rates go down (like they have for much of this century) the liability will go up. And if rates go up, the liability goes down. Directionally, pension liabilities move inversely to interest rates.
The magnitude of how much liabilities move with interest rates is known as the duration of the liability. This can be thought of as how far out the liability is sitting on the arm of the see-saw. The further out on the arm, the higher the liability goes when rates drop (and vice versa), the longer the duration. (Duration is generally expressed as the percentage of change in liability from a 1 percent change in interest rates. A duration of 15 means liabilities change 15 percent for each 1 percent change in rates.)
Assets Ride Too!
Now we’ll assume something unusual, and add a second rider opposite to interest rates: the assets of the pension plan. You’ll notice that the assets sit much closer to the center of the see-saw than the liabilities to reflect the fact that the duration of a typical DB allocation is much shorter than the plan’s liability. (The typical duration of a DB liability is in the range of 10 to 15. The duration of a core bond fund is generally closer to 5. If a plan’s allocation is only 40 percent fixed income, the duration of the entire portfolio would only be 2.)
In this situation, which is extremely common, there is a high level of risk/reward tied to interest rates. If interest rates go down 1 percent, our liability increases 15 percent and our assets only 2 percent. If we assume assets and liabilities start out as equal, the result is a 13 percent net loss, represented by the vertical distance between our two riders after the interest rate move.
If our goal is to minimize the vertical distance between assets and liabilities as interest rates teeter-totter up and down, we would ask the asset to “scooch back” on the see-saw arm to the same spot as the liabilities. In this circumstance, we would expect the change in the assets and liabilities to be the same on a percentage basis when interest rates move.
There are two ways to
- Increase the allocation to fixed income investments
- Increase the duration of the fixed income investments
Unfortunately, many DB plans today are underfunded, so sponsors don’t necessarily want their assets and liabilities moving in exactly the same way. Sure, duration matching greatly reduces risk of new unfunded liabilities when interest rates fall. But it also foregoes positive results when interest rates rise – an event that is being predicted by enough folks to be taken seriously.
For this reason, many sponsors have adopted dynamic asset allocation (DAA) “glidepath” strategies. According to DAA, the duration of the assets is tied to the funding ratio of the plan. When funding ratios are low, duration is held shorter to provide positive net returns should rates rise. When funding ratios improve, duration is “scooched out” incrementally until it matches the liability.
(Financial advisors and actuaries often play the role of “helicopter parents” in this scenario, suggesting to the assets where they should be sitting at any given time!)
The risk of equity market correction isn’t addressed on our see-saw unfortunately. The duration of these investments is assumed to be zero when analyzing these liability driven investment (LDI) strategies as there is no strong, consistent correlation between stocks and interest rates.
You can think of equity market risk as the kid by the swings who just knocked the assets off our see-saw with a dodgeball, leaving the liabilities hanging up high in the air.
I warned you this was a dangerous playground!
Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA) and he’s got the scars to prove it!
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.
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