Matching the duration of fixed-income investments to those of a plan's liabilities is common practice to hedge the interest rate risk in pension plan funding levels. However, in an effort to close their funding gaps, plan sponsors maintain significant allocations to equities and other return-generating assets because of higher expected returns. As pension plans become more cautious about return expectations, we examine the impact of incorporating non-fixed-income assets in LDI allocation policy and manager selection due diligence. We demonstrate that this exercise has provided a low-cost "insurance policy" against funding level declines when a plan's investment portfolio underperforms.
In typical liability-driven investment implementations, the return-generating portion of the portfolio is not considered when evaluating the overall portfolio's asset-liability-matching relationship and interest rate sensitivity. Ignoring the long-term, albeit weak, relationship between these return-generating assets and interest rates can lead to suboptimal results: Each derisking milestone affords a plan fewer opportunities to reach subsequent derisking milestones. Acknowledging the contribution of non-fixed-income assets to funding-level volatility enables plans to maintain higher allocations to return-generating assets than in a traditional LDI framework. Incorporating the right kinds of non-fixed-income assets in an LDI implementation allows plans to participate more in potential market upside while protecting funding level when the non-fixed-income assets underperform.
We refer to portfolio duration as the historical tendency of a pension plan's overall investment portfolio to match the change in the plan's liabilities. More specifically, portfolio duration is defined as the absolute difference between one and the trailing five-year beta of a pension plan's overall investment portfolio returns to the change in the plan's liabilities.
The lower the portfolio duration, the better the pension plan's overall portfolio has acted as a hedge against its liabilities in the past. While market risks shouldn't be thought of as a hedge for liabilities, risks that have been correlated with liabilities in the past have provided a tactical opportunity for pension plans to allocate to return-generating assets.
While investment return, starting funding level and change in inflation are key drivers of change in funding level, portfolio duration, when including return-generating assets, is an incrementally significant driver, above and beyond the role of the change in 10-year Treasury yields. We regressed the year-over-year percentage change in funding level against overall portfolio return, percentage change in inflation, percentage change in the 10-year Treasury yield, and portfolio duration using investment performance and liabilities data for 173 pension plans from 2001 to 2016 (Table 1).