By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There seems to be a fascination in our industry about using the duration of bonds to help mitigate pension funding risk, but does it? Let’s start with the basics. What is duration? Duration is the average life of cash flows priced or weighted by present values (market values). Duration is commonly used as a measure of the price sensitivity of a bond to changes in interest rates. The purpose of duration matching is an attempt to match the interest rate risk sensitivity of assets to liabilities. The objective 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. Problem: because duration is a PV calculation, it is constantly changing, which creates the need to constantly adjust the plan’s asset allocation! More problems: duration is not calculated by the actuary so where do you get the duration of liabilities?

Furthermore, duration matching strategies are implemented by either using a single average duration or by investing in several key rates along the yield curve. The truth is that liabilities are a term structure of monthly liabilities. You need to match this entire liability yield curve to match its interest rate sensitivity. Moreover you have to match or exceed the discount rate used since duration does not include income in its calculation. As a result, a portfolio of US Treasury STRIPS will not match the liability growth rate if liabilities are priced as AA corporate bonds (ASC 715 – FASB rules). Duration is far from a precise mathematical calculation (see Seven Flaws of Duration research on our web site for more insights) given the volatility of interest rates and the fact that yield curves do not move in parallel shifts.

Frequently, duration strategies are implemented by fixed income managers attempting to match the average duration of the bond portfolio to the average duration of a bond market index with a similar duration to the pension plan’s liabilities (i.e., Bloomberg Barclays Long Corporate Index). They use the generic bond index as a proxy for liabilities, but no two pension plan liability streams will ever be the same – they are like snowflakes.

Actuarial practices use PV to calculate the funded ratio and funded status. But benefit payments are future values (FV). This suggests that the future value of assets vs. the future value of liabilities is the most critical evaluation. But most asset classes are difficult (impossible) to ascertain their future value. This is why the PV is used. Only bonds (and insurance annuities) have a known future value and have historically been used to cash flow match (CFM) liabilities (i.e. defeasance, dedication). Importantly, duration matching strategies DO NOT provide the liquidity needed to secure the promised benefits.

What is the primary objective in managing a defined benefit pension plan? It is to SECURE the promised benefits at a reasonable cost and with prudent risk. How does a duration matching strategy secure the benefits? Only a cash flow matching strategy can match and fund the monthly benefits and expenses chronologically. Importantly, a CFM strategy provides a more precise duration matching then duration matching strategies do, as each and every monthly liability payment of the CFM program is duration matched as opposed to a few key rate durations.

Duration matching products are a poor substitute for cash flow matching programs if the desired goal is to ensure that the plan’s promises to the participants are SECURED each and every month, as duration matching products fall short as a result of the following:

1. Duration matching does NOT fund and does NOT secure benefits
2. Duration is a PV calculation so it is very interest rate sensitive – benefit payments are FV and not interest rate sensitive
3. Duration changes every day requiring frequent rebalances
4. Generic bond indexes typically used as proxy for liabilities
5. No generic bond index can match client’s unique liability cash flows
6. Forced into buying costly Treasury STRIPS after 16 years