Since nobody can plan for every contingency, including rising interest rates, the Principal Financial Group recommends that defined benefit plan sponsors use a fixed income strategy that works in any interest rate environment.
It tested out three fixed income strategies using rising interest rates, falling interest rates and rates that stay the same over a 10-year period. Each strategy was evaluated on its impact to funded status and total accounting cost.
What the company found is that a strategy that used a combination of core bonds, which are short- and intermediate-term bonds, and longer-duration bonds to match the plan’s liability duration came out on top in a significant percentage of potential scenarios.
If interest rates decline, use of long-term bonds chosen to match the duration of plan liabilities will help protect the funded status of the plan from decline, the Principal found. When interest rates go down, the value of bonds and that of defined benefit liabilities increase.
When interest rates rise, core bonds are often chosen because the liabilities decline much more than the bonds if bond duration is much lower than liability duration.
The Principal’s analysis demonstrated that the bond strategy with the lowest consistent cost, least volatility and highest return was the middle approach of bond duration equal to plan liability duration.
“In a gradual-movement interest rate environment, whether up or down, added return from long corporate bonds more than makes up for any perceived advantage of staying short if rates materially go up or going ultra-long if rates decline somewhat more,” the report stated.
The company noted that most plans use short-duration bond approach, but that moving to a liability-driven investing (LDI) approach could reduce volatility, thus achieving one of the main objectives of plan sponsors. Choosing a middle approach with bond duration equal to plan liability duration may lead to optimum results, it concluded.