By Shirley Zhang, regional director
Global market volatility and low interest rates have greatly impacted the funded status of corporate defined benefit plans over the past decade. Particularly in the last year, wide swings in equity markets have become less predictable, making funded status volatility a greater cause for concern. As such, many plan sponsors are seeking solutions that hedge against risk and volatility while protecting any improvements in funded status. There are three main sources of funded status volatility and FTSE Russell has identified solutions that can help plan sponsors address each of them.
As we’ve heard time and time again from our corporate defined benefit plan clients, controlling funded status volatility has been a top priority. Pension assets and liabilities have become prominent parts of company financial statements, often used by investors to evaluate company health. This has placed greater urgency on the need to accurately estimate financial risks presented by the plan’s investments.
To develop effective strategies to manage these risks, it’s important for plan sponsors to understand the sources of funded status volatility. Most defined benefit plan funded status volatility can be traced to three main sources:
- unhedged exposures to interest rates
- credit spreads
Each of these risks should be considered and controlled to minimize asymmetric exposure between the market value of assets and the present value of liabilities.
Before addressing the sources of volatility on the asset side, plan sponsors should ensure they’re using the appropriate discount rates to value liabilities. Some still discount liabilities using the expected returns of their assets, but this creates a mismatch between a plan’s risky assets and its almost risk-free liability, and also encourages excessive risk-taking in investments. A more prudent discount rate is one that is built specifically for such purposes. An example of that is the FTSE Pension Liability Index, which is based the FTSE Pension Discount Curve—a trusted source for plan sponsors and actuaries to value pension liabilities.
Once the liability is known, the plan can focus on minimizing interest rate risk by matching durations of the assets with liabilities. In practice, the plan’s assets tend to have shorter duration than its liabilities. To decrease interest rate risk without changing their current manager line up or asset allocation, plans can extend duration or fine tune key rate duration to match that of the liability by using Treasury STRIPS, or derivatives such as futures and options. The FTSE US Treasury STRIPS Index offers a range of duration choices, and interest rate-based derivatives can be access through various exchanges.
With respect to credit spreads, plans often allocate to long duration corporate bonds to better match their assets to liabilities. It’s important for plans that are still accruing or have high liability cash flows to look for ways to maximize return in this asset class while not changing the duration profile such that it incurs more interest rate risk or spread risk. At FTSE Russell, we’ve conducted research and demonstrated that fixed income returns can be enhanced without taking on duration bets.
With interest rate risk and credit spread risk strategies in place, plan sponsors can turn their attention to the residual volatility coming from the risk-seeking part of the portfolio—namely equities. This is where defensive considerations can be implemented—through the use of indexes such as low volatility indexes—particularly given their higher correlation to a typical pension liability relative to comparable market cap weighted indexes. Additionally, improved funded status from the record-long bull market, coupled with the recent increased market volatility, should be sending a signal to plan sponsors that it’s time to focus on protecting funded status and reduce draw-down risk of equities.
FTSE Russell is already working with defined benefit plans to help them identify which solution best suits each plan. We have the capability to focus on a single asset class or to look across multiple asset classes for a customized, optimal solution for our corporate plan clients. For more detail about how FTSE Russell can help address these issues, and about the products we have available, please read our latest Insight, “A focus on funded status volatility of corporate DB plans.”
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