NEW YORK — For corporate pension funds, the use of interest rate swaps might be the answer to getting the albatross of long-term liabilities off their necks.
Research analysts at Merrill Lynch & Co., New York, are proposing in a new paper that corporate pension funds use interest rate swaps to ease the burden of long-term liabilities, because swaps would enable a pension fund to synthetically increase the duration of its portfolios to match liabilities.
Addressing long-term liabilities and funding status has become a priority for corporate plans, especially given the prospect that mark-to-market pension accounting for U.S. corporations could become the norm in the next few years. Mark-to-market accounting would increase the volatility of corporate pension fund portfolios, given that it would eliminate such accounting methods as actuarial smoothing.
An interest rate swap is a complex derivatives structure in which a holder or issuer of a security bearing a floating-rate coupon finds a counterparty holding a security bearing a fixed-rate payment. The two parties can swap the rates on their respective instruments, usually for a small fee paid by the holder of the floating rate security. Such a transaction is typically coordinated through an investment bank.
According to the paper, "Pensions & Endowments 4: Swapping the Paradigm," a corporate pension plan with a standard 70/30 split between equities and fixed income that is not hedged against interest rate risk could see a 12% to 15% hike in liabilities with only a 1.5% gain in asset appreciation. The paper was written by Adrian Redlich, a senior vice president in Merrill's pension and endowment strategy group, and Gordon Latter and Shuaib A. Siddiqui, vice presidents.
A plan with a 70/30 allocation to equities and debt using an interest rate swap overlay strategy would have improved its asset-to-liability ratio in every rolling 10-year period since 1975, according to the paper. Conversely, a plan with the same asset allocation but not using a swap overlay strategy is four times more likely to be underfunded at the end of any given year than a plan that uses the strategy, the paper said.
In the study, Mr. Redlich also argued that using a swap overlay strategy is preferable to implementing a fully immunized portfolio.