Pension plans are winners amidst the bond market turmoil
Categories: Category: Defined benefit strategy, Liability driven investing, Market volatility
Interest rates leapt up in June. The yield on the benchmark ten-year Treasury bond rose above 2.5% for the first time in nearly two years, ending the month at 2.52%, which is more than a full percentage point higher than the lows reached last summer.¹
For most investors, that translates into bad news: a drop in the value of their bond portfolios.
Pension plans are different, though: while pension plans do hold bonds in their asset portfolios, that exposure is small in comparison to what lies on the liability side of their balance sheets. For them, a rise in yields translates into good news: a drop in the value of their liabilities.
That’s because pension promises are structurally the same as bonds: they are a promise to pay a specified amount of money at a specified point in the future. So it’s normal these days to value liabilities based on the price of bonds. The chart below, based on data in Russell’s monthly LDI update, shows how a representative pension plan’s asset and liability values have evolved in 2013 to date. The chart shows valuations of the assets and liabilities at monthly intervals from the start of January through the end of June.²
This hypothetical illustration is not meant to represent the results of an actual plan.
This plan’s funded status – shown in gray – went up by 7% in the year to date. It increased in June, despite the fact the equity market³ fell by almost 3%. So even though the asset portfolio – shown in black – fell substantially (down 3.6%), the liability value – shown in blue – fell by more.
Looking at the year as a whole, of the 7 point improvement across the year to date, around 3 points have come from rises in the equity market and 4 points from the fall in interest rates. That’s a timely reminder the management of a pension plan is now at least as much about managing the exposures on the liability side as it is about managing the exposures on the asset side.
¹Based on U.S. Department of the Treasury data at www.treasury.gov/resource-center.
²Full details of the calculation methodology, including key assumptions, are provided in our monthly LDI update to which a link is provided above. Note that the effects of benefit accruals, contributions and benefit payments have been assumed to cancel each other for the purposes of this analysis.
³As measured by the Russell Global index.