Let’s take a look at the impact on pension plans of interest rate increases by the U.S. Federal Reserve (the Fed) and explore some considerations for implementing a liability-driven investment (LDI) strategy.
Current interest rates and bond markets: Favorable for many investors
Over the last 18 months, the Fed has raised interest rates eleven times, from 0% to 5.25%, causing yields on 10-year Treasuries to rise from 1.52% at the end of 2021 to 4.27% as of September 2023. Additionally, the whole Treasury yield curve has risen, regardless of term.
The impact of this has been, in many cases, favorable for insurance companies and pension plan sponsors, as the rise in interest rates normally leads to a lower value of liabilities.
In addition, fixed income and equity markets have generally produced positive returns from January 2018 through August 2023. We created a hypothetical investment portfolio with 60% of assets allocated to the S&P 500 Index and 40% allocated to the Bloomberg U.S. Aggregate Bond Index, and calculated an approximate positive return of 46% over that time period.
Figure 1: Fed Funds Rate, 2018-2023
Figure 2: U.S. Treasury yield curve movement, 2018-2023
Pension plan funding levels improved
As a result of rising interest rates and generally favorable investment returns, corporate pension plan funded status has risen from 89.4% in 2018 to more than 103% as of the end of August 2023, according to the Milliman Pension Funding Index (PFI), which monitors the 100 largest U.S. corporate defined benefit plans. In addition, we have seen discount rates rise from 2.46% in 2020 to 5.84% as of the August PFI currently.
Figure 3: Data from the Milliman PFI analyzing the 100 largest U.S. corporate pension plans
As we have seen, with the rise in discount rates and funded ratios over the last couple of years, it would make sense for plan sponsors and investment committees to review their assets and liabilities collectively.
How does an investment committee review assets and liabilities collectively?
To start the discussion on how one should look at this, let’s have a refresher around what LDI is, then get into the asset-liability modeling (“ALM”) process and how to implement a liability-driven approach to manage a pension plan. Yes, I said manage a pension plan, not only the investments. An effective process for managing a pension plan requires an understanding of both the plan liabilities and assets, and more importantly making them work in unison.
What is LDI?
In short, an LDI strategy is a risk-management strategy utilized by pension plan sponsors and insurance companies to align the asset side of the equation with the structure of liabilities. In essence, it drives the policy for the supporting investment portfolio by attempting to minimize the funded status volatility by hedging interest rate impact on future liabilities. LDI strategies are often considered or implemented as funding levels approach or exceed a fully funded level, and may be implemented in a partial, glidepath, or fully implemented/fully hedged allocation strategy. A typical “Traditional Investment Portfolio” only focuses on building an optimal portfolio from a risk and return perspective, without taking into consideration the overall asset-liability picture.
Figure 4: Traditional Investment Portfolio
Figure 5: LDI Hedging Portfolio
Asset-liability modeling
To determine the feasibility of implementing an LDI strategy, an investment committee typically works with a consultant who analyzes projected future cash flow obligations, reconciles the current investment portfolio to the liabilities, and identifies where there may be opportunities to better align the investments with the liabilities.
Liability analysis
In this phase, the future projected cash flows are analyzed. It is important to develop an understanding of the structure of when cash flow requirements will happen, and the impact of interest rate changes on the value of those liabilities. Typically, these cash flows are actuarially projected many years into the future. To determine the duration of the projected future cash flows, a yield curve is utilized to discount the future cash flows to today’s dollars. In the example shown in Figure 6, we determined the overall duration to be 14.2 years. This means that a change in interest rates of 100 basis points may cause the value of liabilities to change by approximately 14.2%. In this case, that would mean by about +/- $17 million based on the present value of liabilities. We also analyzed the liabilities in segments, from short term to extended term, to understand how each segment, along with the overall total, may be impacted by rate changes.
Investment portfolio review
Assets within the portfolio are defined and assigned to various asset categories, from fixed income to equities and alternatives. From the allocation, it can be determined how investments within specific asset categories could react in various market conditions and how the allocation overall will drive the portfolio. Most importantly, based on their duration, fixed-income investments within the portfolio are assigned to asset categories in four segments, like those “buckets” the liabilities are segmented into (short, intermediate, long term, and extended duration). This allows the matching of assets covering liabilities in these segments. In our example, the plan sponsor has been focusing more on capital appreciation and investment growth than on hedging funded status volatility, with the portfolio allocated mostly to equity. Also, the hedge ratio is only around 5%, meaning the portfolio has been designed more for capital appreciation and growth and not to hedge liabilities. Not that there is a problem with a large equity portfolio allocation. In fact, many sponsors have utilized the rising equity markets that often occur after sharp market declines to grow their asset portfolios and improve the plan’s funded status. However, now may be the time to change strategies, which we will explore.
Figure 6: Duration of projected liabilities
Figure 7: Projected benefit payments and liabilities
Figure 8: Asset details and portfolio metrics
Understanding how assets and liabilities work together
To understand how well an asset portfolio is “covering,” or what assets are in place to fund current and future liabilities, it is important to reconcile the underlying asset portfolio to liabilities. Within this process, it is important to determine the types of assets in place to offset future liabilities. Looking at our liability segments, we identify those assets that match to the liabilities; in most cases, this is fixed income assets based on their duration. We place cash and short-term fixed income in the “Short” segment, core fixed income in the “Intermediate” segment, and so on, until we’ve allocated all the plan assets into the corresponding liability segments. Note that we place equity investments in the “Extended” segment, which, in our example, has a duration of zero years. In the portfolio example we are reviewing, approximately 75% of the assets are allocated to equity.
Figure 9: Allocation and duration details
Now that we have our assets and liabilities accounted for, we start to define what risks are present.
Market risk and interest rate changes are two key risks that will impact both sides of the pension funding equation. Under the asset allocation area of focus, we have the impact of interest rate changes on the investments in bonds, as well as the equity market impact on stock-based investments. Changes in interest rates also affect the value of annuities and pension liabilities. Collectively, market and interest rate movements are a significant driver in funding level volatility. For example, if the plan liabilities have a duration of 14 years and interest rates fall by 1%, the value of liabilities could potentially increase by 14%. Add to that equity markets that continually move and you’ve got tremendous potential to see a high degree of funded status volatility. For perspective, in our example above, our 75/25 portfolio had a standard deviation of 13, meaning that returns could vary from -7% to 19%, impacting assets that support liabilities and obligations.
Market impact
To illustrate the potential variability of market returns, it is important to understand how a portfolio may react in times of stress. By evaluating how different portfolios would have reacted to historical economic scenarios, we can gain a better understanding of how a portfolio may respond in a future market event. Although this is mostly “market”-side impact, it does help committees to understand how various allocations may behave, if and when something happens.
Figure 10: Market events
Funding level sensitivity
Sensitivity analysis shows us the potential impact to funded status based on interest rate changes and market movements. Understanding how funded status may rise or fall when interest rates change and market volatility happens allows investment committees to determine the potential risk of their allocations. It also illustrates how allocation changes and levels of hedge (Full LDI Hedging or Partial LDI Hedging in Figure 10) could reduce funded status volatility. As we can see, the Full LDI and Partial LDI (Scenarios 2 and 3) reduce the funded status volatility under the interest rate and market movement compared to the Current Allocation and Scenario 1. This indicates that it may be advantageous for plan sponsors and organizations to consider the benefits of an LDI strategy.
Figure 11: Sensitivity analysis: Potential funded status change based on market and interest rate movements
Actions for pension plan sponsors to manage funded status volatility by implementing an LDI strategy amid high interest rates
As we have seen in the past five years, rising interest rates and favorable investment markets have caused corporate pension plans’ funded ratios to improve from 89% to more than 100%, based on the Milliman 100 PFI. As a result, it may be wise for companies and investment committees to collectively analyze their liabilities and assets to determine if now might be a good time to implement a liability-driven investment strategy. It should be noted that once you’ve implemented an LDI strategy, it is important to review it periodically and adjust as necessary in order to continue to reap the benefits of this tool.