Pension plans could improve funding ratio by switching to long-term bonds

Although equity markets came back in the first quarter of 2012, the financial status of pension plans has only improved slightly, according to Aon Hewett. The median pension funded ratio of a large sample of pension plans increased only 1 percentage point to 69 percent from the end of 2011 to March 2012. About 97 percent of pension plans in this sample were running a deficit.

A pension plan’s funded ratio measures its total plan assets against its liabilities, or what it must pay out to pensioners every year.

According to the report, the average pension fund earned an average 3.6 percent in the first quarter.

"The interest rates used in a March 31, 2012, solvency liability calculation are broadly comparable to the interest rates at the end of 2011," said Thomas Ault, an associate partner and actuary with Aon Hewitt in Vancouver. "Interest rates are still at historically low levels, which mean solvency liabilities remain very high." 

André Choquet, an investment consultant and actuary with Aon Hewitt in Toronto, said that, “The results of the first quarter underscore the importance of assessing defined benefit pension plan performance in an asset-liability framework, as good asset performance was overshadowed by increased liabilities. By thinking about plan assets as either liability-hedging or return seeking assets, plan sponsors can better manage the risk inherent in each component.”

He added that pension plans have been investing in universe bonds with five and 10-year terms. Switching to long bonds, with maturities between 10 and 30 years, will more closely match the plan’s liability cash flows and help assets and liabilities behave in tandem when interest rates fluctuate.

Many pension plan sponsors are avoiding making the switch from Universe to Long Bonds, partly because of the prevailing low interest rates.  This is because sponsors who are invested in shorter duration bonds may see a more dramatic improvement in their funded position (relative to sponsors who invest in longer duration bonds) if interest rates were to increase above their current levels.

For sponsors with this perspective, it is more important than ever to establish a formal risk strategy for the hedge fund portfolio, so that an appropriate and measured amount of risk is taken within their pension plan.  This may mean introducing a strategy to switch from Universe to Long bonds if interest rates hit pre-determined levels, the report found.

Aon Hewitt is the global leader in human capital consulting and outsourcing solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance.

 

 

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