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Aon Retirement and Investment Blog

Is this the one? Who cares…take action like it is.

Since the U.S. slipped into the financial crisis seven years ago, and the 10-Year Treasury yield plummeted toward 2%, a debate has dominated every financial conversation: are rates finally starting to rise? Is this the one?
During this period, the yield on the 10-year Treasury has risen at least 50 basis points in less than a month 10 times. Each time that has happened, I’ve received the same email from a friend or colleague telling me that they hope I’ve locked in my mortgage because this is it…
…and yet it wasn’t. Each time, that self-ordained oracle has been wrong. But I am here to tell you that after watching the 10-year rise by over 60 basis points from April 17 to June 10, this is it…
…but maybe it isn’t.
For sponsors of U.S. corporate defined benefit pension programs, whose pension liabilities are linked to long-dated U.S. corporate bond yields, this roller coaster has been excruciating. In the period mentioned above, the aggregate funded status of the pension plans of the S&P 500 companies rose by nearly 5% from 80.5% to 84.9% in spite of global equities being unchanged during that time (source: Bloomberg MSCI ACWI).

Why? Because that rise in Treasury rates drove discount rates 80 basis points higher, which alone eliminated about 8% of the market value of the S&P 500’s pension liability.
The fortunate sponsors with May 31 and June 30 fiscal years have been able to lock-in these nominally high discount rates of around 4.50% (using AA corporate bond rates) for their next fiscal year P&L—driving 2016 pension expense down in nearly every instance.
For many, it is a frustrating commentary on the economics of pension plans that sponsors find themselves yearning for a 4.50% discount rate. However, the silver lining is that over the last seven years, many sponsors have implemented dynamic investment policies (e.g., glide paths) that allow them to take advantage of these small spikes in interest rates even if they can’t capture the benefit in their P&L.
During this recent spike in rates, fixed income investments suddenly became meaningfully cheaper (on a relative basis) than they were just a few months earlier.  While sponsors have a hard time telling themselves that a 10-year Treasury rate of 2.50% represents  a good opportunity to buy fixed income, these same investors have learned to sell equities during bull markets to “lock-in” their gains. A glide path provides a strategy to exercise the same discipline with rises in interest rates. Sponsors with glide paths buy into fixed income over time, likely as interest rates rise, so that they are fully hedged once their pension plan is fully funded.
You may be among the majority of our U.S. clients that have a glide path or are planning to implement one in 2015, in which case you may be asking yourself: why does this guy think he’s telling me something I don’t know? This is exactly why I put a glide path in place!
If so, then my question for you is: did you rebalance during that two month period?
Because a 5% rally in funded ratio is significant and these spikes are why glide paths were built.
Efficient measurement and trade execution are as critical as having that glide path in place to begin with. Just six days after the peak on June 10 that I mentioned, the aggregate funded ratio of the S&P 500 fell back to 83.5%, giving back about one-third of the gains that had been earned over the prior eight weeks.

Aon Hewitt acts as a delegated investment manager for over 100 U.S. pension plan sponsors (and nearly another 100 outside of the U.S.). During the eight weeks in question, we rebalanced 21% of Aon Hewitt’s clients’ portfolios towards fixed income—locking-in more fixed income investments at higher interest rates and advancing down client glide paths.
If you did not experience a rebalancing event, you may not be measuring closely enough.
So you have a glide path; you even experienced a de-risking event recently.  Is that the whole story?
Almost. The last implication of this recent spike in rates is the implication of intra-year movements on lump sum windows.
If you are running a lump sum window in 2015, you have probably locked-in the interest rate used for calculating those lump sums, and odds are it was based on rates from the fall of 2014. For quite a while, that was looking like it would be a good story for many sponsors, especially those on international accounting rules.
Since interest rates had fallen in early 2015, the amount of liability settled in a 2015 lump sum window would turn out to be greater than the lump sum paid—i.e., eliminating more than a dollar of liability for each dollar of benefits paid. However, it is now critical to monitor this relationship more closely, as rates are now back to where they were in the fall and that relationship is very close to 1:1. It is even possible that we may see sponsors settle less than a dollar of liability for each dollar of benefits paid.
If you are planning or thinking about a lump sum window for 2016, this recent rise in interest rates, should it hold, should provide some relief as we approach August and September when most sponsors’ lump sum rates are locked in for 2016. Ideally, those rates would be locked-in near a relative peak in interest rates to minimize the nominal size of lump sums and creating greater potential for settlement gains in 2016.
So while you are being bombarded by the prognostications that this is the one, just as I am, it’s important to know that whether or not the prognosticators are correct there is plenty of reason to take each of these spikes seriously and find the opportunities to reduce and manage pension risk within the spike.
Matt Maloney is a partner working out of the Norwalk office.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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