February 11, 2014
For typical single-employer pension plans, interest-rate risk is the largest source of funded status volatility. Interest-rate risk arises because changes in interest rates have a disproportionate impact on pension plan assets and liabilities — causing volatility in the surplus position of the plan. This generally comes about because of mismatch between the dollar duration of a plan’s liabilities and assets. A duration mismatch, generally with the plan’s liabilities having a higher duration than the plan’s assets, means that a pension plan’s deficit will increase with declining interest rates. This is what pension plans have experienced during the past decade. Persistent downward movement in interest rates created ever-widening deficits in pension plans.
This Spotlight analyzes the prevalence of interest-rate risk in single-employer pension funds and discusses the benefits of interest-rate hedging as a way to minimize funded status volatility. Considering interest-rate positioning relative to current market pricing is now more important than it was just one year ago.
Having a view that future interest rates are going up may not be enough to justify large tactical interest-rate bets: intentionally holding less duration in an asset portfolio than is present in the plan’s liabilities. It is a question of whether future rates are higher than the break-evens priced into the market.