Pension plan sponsors should consider hedging labilities more evenly
While many believe discount rates could rise in the future, current dynamics suggest this rise will be due to a steeper yield curve, which may result in a decrease in funded status.
While COVID-19 dominated headlines, another tumultuous topic for corporate and other single-employer pension plans during 2020 was discount rates. Many plan sponsors are fully aware of how falling discount rates have resulted in larger liabilities and potentially lower funded statuses for their pension plans. What is driving the discussion now is the path of discount rates going forward. While many believe discount rates could rise in the future, current dynamics suggest this rise will be due to a steeper yield curve, which may actually result in a decrease in funded status for plan sponsors employing certain liability-hedging strategies.
While we believe robust liability hedging remains a bedrock of prudent pension risk management, given a heightened risk of yield curve steepening, plan sponsors should (re-)evaluate their asset/liability interest rate risk and reposition their liability-hedging portfolios as needed.
Understanding Treasury yield impact on discount rates
Discount rates for pension plans are inherently tied to market interest rates, and specifically Treasury yields, which reached historic lows in 2020. A common school of thought is that these are certain to rebound, which should lead to healthy funded status gains in the future.
While such statements have been said plenty of times in the past, perhaps this time rising rates may actually occur. A heap of fiscal and monetary stimulus, the arrival of the COVID-19 vaccine, and hopes and prospects for a boisterous economy would usually pave way for a rise in interest rates.
Typically, increases in Treasury rates would lead to funded status gains – unless the plan is not properly positioned for these events. In certain situations, pension plans may actually lose funded status even though discount rates increased!
To understand how this could happen, let’s first explore rates a bit deeper. There is now consensus that the short end of the yield curve is bound to remain low, given the Federal Reserve’s commitment to maintain the Fed Funds Rate near zero.
If any near-term rise in rates comes to fruition, it would occur by what is described as yield-curve steeping, where the longer dated part of the yield curve rises more than the short. To say it another way, this may occur if the yield on a 30-year bond rises more than the yield on a 10-year bond, and much more than the yield on a 2-year bond, which is more anchored in place by the Fed.
Such rate moves already happened during 2020. Since the end of July and through year-end 2020, the 30-year rate increased by 48bp, the 10-year rate increased by 40bps while the 2-year rate increased by less than 2bps. This trend can certainly continue in the future.
A historical analysis of Treasury rates over the last 40+ years indicated that the yield curve does tend to steepen, and quite dramatically, during periods of economic recovery periods. On average, the 30-year rate moved as much 60 bps over multiple months, while the 2-year rate remained fairly level. In certain events, the figures above were 3 times as large. While this nuanced change in the yield curve may be considered a minute detail by some, it could actually pose funded status risk to many pension plans.
Now let’s inspect how these rate trends can lead to a loss in funded status. A common way this could occur is when pension plans construct liability-hedging portfolios using a combination of long duration STRIPS and long corporate bonds.
While this approach provides a simple, transparent, and capital-efficient way to achieve a high overall interest rate hedge ratio, the resulting liability hedge is uneven. (Note: Interest rate hedge ratio refers to how well the asset portfolio offsets changes in liabilities due to interest rates. A higher hedge ratio implies that assets offset a higher portion of liability changes.)
Rate changes at the long-end of the curve are hedged much more than rates at the short-end. For plans that are mature or well-funded, this structure can lead to an overhedge at long dated parts of the curve. This design means that if long rates rise (while short rates remain level), fixed income assets would fall in value more than liabilities.
This would lead to unintuitive – and potentially detrimental – results, especially if the yield curve steepens materially. For example, if rates in the 20-30 year maturity rise significantly more than rates under 20 years maturity, the overhedged part of the curve would result in losses to funded status, without being fully compensated by any funded status gains resulting from the underhedge at the short-end of the curve.
Advice for plan sponsors
In order to avoid this potential outcome, plan sponsors should specifically avoid overhedging interest rate risk at longer maturities and should also consider hedging more evenly across the yield curve. This is especially true for mature and well-funded plans where the impact of an uneven hedge is larger.
This nuanced approach requires either a custom solution, which may involve derivatives, or the transfer of long maturity strategies to lower maturity strategies, such as intermediate and core fixed income.
Plan sponsors with an appetite for interest rate risk and high degree of conviction of yield curve steepening could also consider a tactical approach. This approach would specify the interest rate hedge at different maturities based on the level of the 30-year rate or the steepness of the yield curve. The design would result in lower hedge ratios today that would increase as the yield curve steepens until it reaches a certain pre-determined level. Developing and monitoring such a framework is paramount to achieving success and also represents prudent management of asset-liability risk management.
As is often the case, these approaches to liability hedging are a balancing act that involves not only risk considerations but also additional portfolio and benchmark complexity, enhanced asset-liability (and yield curve) monitoring, and potentially higher investment management costs.
Given the heightened potential for yield curve steepening, all plan sponsors should become more aware of the yield curve risk embedded in their liability-hedging portfolios and, potentially, re-evaluate their liability-hedging approach. Not doing so could lead to undesirable widening of the asset-liability deficit in what is already a volatile and uncertain market environment.
