Pension Liabilities Are A Term Structure

By: Russ Kamp, Managing Director, Ryan ALM, Inc. and Ron Ryan, CEO, Ryan ALM, Inc.

Plan Sponsors and their advisors need to focus on the economic value of the pension plan’s liabilities, which are a yield curve or term structure of actuarial projections of benefits and expenses. Pension liabilities are not a single maturity or duration on a liability yield curve. Anyone who knows the Ryan ALM organization knows that we espouse cash-flow matching (CFM) for that very reason. With CFM you get not only the liquidity to fund monthly benefits and expenses, but you also get duration matching for each and every month that the CFM portfolio covers. Unfortunately, with duration matching, you are only able to “match” the interest rate risk sensitivity of assets to liabilities at a single point in time (average duration) or a handful of points (key rate duration of 5 to 7 average maturity spots on the liability yield curve).

The objective of duration matching is to have the market value or PV changes (growth rate) in the bond portfolio match the market value or PV changes (growth rate) in liabilities for a given change in interest rates. Many fixed-income managers attempt to match the average duration of the bond portfolio to the average duration of a generic bond market index with a similar duration to liabilities (i.e., Bloomberg Barclays long Corporate index). They use the generic bond index as a proxy for liabilities.

Unfortunately, there are many issues with this approach, including:

  1. A generic bond index cannot replicate any client’s unique liability cash flows. A client’s liabilities are like snowflakes: different labor force, salaries, mortalities, plan amendments, etc.
  2. Average durations give erroneous information because there is an infinite number of combinations of maturities for a bond portfolio that can all have the same average duration, but they will not have the same risk/reward profile.
  3. Duration matching is only accurate for small parallel shifts in the yield curve. But the yield curve rarely moves an equal number of basis points at every point along the curve.

Speaking of the yield curve, just look at how the shape of the US Treasury yield curve has changed in the last 14 months, as the Federal Reserve has tightened monetary policy as they aggressively fight inflation. Has the Treasury yield curve moved both incrementally and in parallel? Absolutely not! The short-end of the curve has seen a dramatic rise, as 1-month T-bills are up nearly 5.5% since the Fed ended its zero-interest rate policy, while longer-term US Treasury note and bond yields have only ratcheted up marginally, in most cases < 80bps during that time frame.

If you are an asset consultant or plan sponsor that wants to truly address interest rate risk while enhancing the fund’s liquidity to meet the promised monthly payouts then cash flow matching is the strategy that should be used and not duration matching. For more information on this subject please go to where Ron Ryan and the team have produced a plethora of research on these concepts.

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