For many years, there has been a lot of discussion among consulting actuaries and investors (both plan sponsors and managers) about whether or not to increase the duration of Fixed Income portfolios.
We are a strong believer that investing in long duration bonds is the most appropriate approach for better matching pension assets with recognition of the plan’s liabilities 1
(as a better risk management tool). However, we also believe the debate between long- and short-duration bonds is becoming somewhat futile for the following reasons:
1. As bond yields continue to decrease, the risk benefit of investing in longer-duration bonds remains the same but the cost benefit is reduced. For more than 10 years, many investors have expected bond yields to increase, and have decided not to increase their bond duration. The more they wait, the better positioned they will be when yields start to go up - but at what cost? Like many, we believe yields will eventually go up. The question is: When?
2. The DEX Long Term index represents a better proxy for pension plan liabilities but this is really only valid for plans allocating the bulk of their assets to long-duration
Fixed Income securities. To best illustrate this and better compare apples with apples 2 , we must multiply the duration of the Long Bond component by its portfolio weight. For example, for a plan invested 50 per cent in
Equities and 50 per cent in Long Bonds, the duration is approximately six years while the duration of the liabilities remains at 12 to 15 years. Undoubtedly, increasing the portfolio duration from three years (50 per cent x DEX
Universe duration) to six years does represent an improvement, but it is still nowhere near the 25 to 30-year portfolio duration required to properly match the liabilities.
3. More importantly, it is becoming ever more clear that no matter what happens to interest rates, the bulk of the pension risk relates to equities and other non-Fixed
Income investments. In fact, based on commonly-used assumptions, it is often understood that for a typical
55-60 per cent Equity/40-45 per cent Fixed Income portfolio, 85 per cent of the risk is associated to equities.
So refining the Fixed Income benchmark, without a significant change to the Policy Asset Mix represents an interesting, but less useful exercise.
For most plans, the 2008 financial crises created larger deficits than the one experienced following the bursting of the tech bubble. By mid-2009, everyone realized there was a need for better risk management. A few investors took actions, but for many, the concept quickly disappeared with the turnaround in the equity markets 3.
So with long bond yields sitting at around 3-4 per cent, what are the options for plan sponsors who would like to better manage their pension risk?
1) Do nothing and continue to hope the situation will change soon;
2) Immunize their portfolios, i.e. take the ‘hit’ and fund, over time, the deficits currently estimated by actuarial firms at around 20-30 per cent of the liabilities;
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We believe investors should go back to the drawing board and revisit one of the key tools used in the past decade to manage risk, i.e. the Asset/ Liability Modeling (ALM) also referred to as Stochastic Projection. While a valuable tool, this modeling has two major drawbacks:
1) it is highly dependent on the assumptions being used; and, most importantly,
2) the financial assumptions are based on historical long-term averages most often based on Normal distributions.
Graph 1 below presents some historical data on the volatility level (measured using a 30-day rolling standard deviation) of a standard pension plan equity portfolio
(50 per cent S&P/TSX and 50 per cent MSCI World).
Graph 1 – Historical volatility of a standard equity portfolio
Expected values
Real return
Standard deviation
Correlations
Short term securities
Long term bonds
Canadian equities
Foreign equities
Short term securities
1.0%
2.5%
1.00
0.90
0.20
0.10
Long term bonds
2.0%
5.5%
1.00
0.20
0,10
Canadian equities
5.0%
Foreign equities
5.0%
17.0% 15.0%
Average ≈ 15%
1,00
0,80 1.00
The results emanating from a 10-year stochastic analysis applied on a standard asset mix profile (60 per cent
Equities and 40 per cent Bonds) and using the assumptions above are shown in Graph 2.
Graph 2: 60/40 mix – Normal equity volatility ( ≈ 15%)
As illustrated in Graph 1, the volatility level is far from constant and fluctuates widely over short time periods 4 .
As a result, using constant volatility assumptions in ALM studies can lead to poor risk assessment and sub-optimal asset allocation.
The table below displays a typical set of financial assumptions used in Asset Mix or ALM studies. For the purpose of this case study and for simplicity, we have conducted a simple Asset Mix study; however the pattern of results would be similar under an ALM study.
As expected, the range of outcomes is quite extreme in the short run. We also note that it still remains very high in the long run.
Now let us revisit those results by changing a single parameter - the level of standard deviation used for
Equities. In the first scenario (Graph 3A), we have doubled the level of volatility (from a combined level of
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GOING LONG OR SHORT-DURATION BONDS continued from page 2 approximately 15 per cent to 30 per cent) whereas in the second scenario (Graph 3B), we have halved the volatility from 15 per cent to 7.5 per cent.
Would a plan sponsor be as comfortable investing 60 per cent in Equities under the extreme range of outcomes depicted in Graph 3A under a high equity volatility scenario, compared to the normal level of volatility?
Conversely, as illustrated by the much tighter bands in
Graph 3B, why should a plan sponsor restrict the equity exposure to a 60 per cent level when the volatility is lower than the long-term average?
Graph 3A: 60/40 mix – High equity volatility ( ≈ 30%)
Graph 4: 100% Long Bonds
Graph 3B: 60/40 mix – Low equity volatility ( ≈ 7½%)
As seen in the graphs 2 and 3, the results used for the determination of the long-term, strategic asset allocation are highly dependent on the underlying assumptions. In fact, it is interesting to note that the Low Equity Volatility scenario (Graph 3B) offers better results (lower range and higher median returns) than those where all assets would be invested in Long Bonds (Graph 4).
Obviously, it is not an easy task to predict the level of volatility at a given point in time. Fortunately, it has been well documented that the predictive power is greater for volatility than returns. As shown previously, the volatility does vary over shorter time horizons. Therefore, a more dynamic approach to managing volatility would likely help plan sponsors better manage their pension risk on a shorter-term basis.
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There is no doubt that bond yields will eventually go up.
However, as it has been highlighted in this article, whether you decide to invest in Long Bonds or not, the potential for an increase in yields unlikely constitutes a key risk for pension investors (assuming Equity exposure remains high). In fact, when bond yields start to go up, solvency/ accounting deficits will likely go down, therefore reducing the liabilities payments.
In an industry operating with short-term requirements such as ours, the biggest component of risk relates to the
Equity component of a plan. It is therefore important for pension plan sponsors to:
• Have a better understanding of the behaviour of this asset class in different market environments; and
• Consider separating short-term risk management (using more current volatility parameters) from long-term strategic asset allocation (using long-term assumptions).
Applying a more dynamic approach to risk management will likely help plan sponsors achieve their financial objectives. For those who have not acted yet, the market turmoil experienced in August and September no doubt served as a wake-up call and reinforced the need for better risk management.
Inquiries or comments concerning this article may be addressed to:
Éric Fontaine , FSA, FCIA, CFA
Senior Consultant & Director,
Multi-Manager Strategy efontaine@pavilion corp .com
1 A typical Canadian pension plan has a liability duration ranging from 12 to 15 years. For comparative purposes, the most commonly used Fixed Income benchmarks, the DEX Universe and DEX Long
Term indices, have durations of approximately six and 12 years, respectively.
2 Although not addressed in this article, other measures such as the structure of the liabilities and convexity should also be considered in an asset/liability program.
3 It is worth noting that despite the strong market rally of nearly 100% experienced from March 2009 to early 2011, markets are still 20-30% below their peaked reached in late 2007 and early 2008.
4 It is noteworthy that the median level of volatility experienced during this time period was 10 %. This means that 50% of the time, the volatility has been at least 2% lower than the 12% average.
LONG OR SHORT DURATION BONDS – OCTOBER 2011