US - Sponsors of defined benefit (DB) pension plans are using liability hedging to reduce the volatility of the plan's funding status, new research by Mercer Investment Consulting has found.
According to Mercer IC’s Summary Performance of US Institutional Portfolios survey, the median corporate, public and foundation/endowment plan posted a gain of 8.1% in the fourth quarter of 2004. Public plans gained 8.4% while foundation/endowment funds posted a return of 8.2%.
“Sponsors of defined benefit plans continue to seek ways of reducing pension risk,” said Brad Blalock, senior consultant with Mercer IC in the US. “One approach is to reconfigure the investment portfolio in a way that better matches assets to the plan’s underlying liability stream.”
Mercer said sponsors were gradually embracing an asset-liability framework consisting of liability hedging, return enhancement, and absolute return.
“The liability hedge component within the framework is the anchor, providing sponsors with a strategy to reduce the volatility of the plan’s funding status,” Mercer said in a statement.
“The mismatch in duration of a typical plan, approximately 12 years for liabilities versus 4.3 for fixed income assets, is likely to cause the dollar-duration of fixed income assets to differ from the dollar-duration of the liability of most plans. This, in turn, causes the funded status to be volatile.”
Two main methods available to sponsors to reduce pension funding volatility are: lengthening the duration of the fixed income mandate or extend duration through an overlay strategy, for example interest rate swaps.
Lengthening the duration of a fixed income mandate is achieved by changing the benchmark to a long government or credit benchmark.
“Since a typical plan allocates approximately 35% to 40% to fixed income, this type of change is not dramatic but simply an incremental step towards increasing the correlation between asset and liabilities,” Blalock said.
The use of derivatives allows a sponsor to increase the overall duration of the assets beyond the limits of a fixed income benchmark change.
“A primary benefit for not changing managers or mandates is the sponsor’s belief that the current manager will continue to add alpha to the overall portfolio,” Blalock said.
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