The rapid widening of credit spreads led to higher pension discount rates, which actually decreased pension liabilities. Credit spreads have narrowed since the extremes of mid-March, increasing pension liabilities. However, US Treasury rates remain near all-time lows, keeping liabilities elevated and limiting improvements to funded status.
It’s clear that plan sponsors must pay close attention to these factors as they consider portfolio construction. Many pensions have migrated in recent years toward larger allocations of long-duration fixed income in an effort to offset liability risk. While credit risk remains an important consideration, exposure to Treasury rates has plainly had the largest impact year to date. Plans that were underhedged on the interest rate side likely experienced declines in funded status and pension surplus—and more volatile paths along the way.
A completion overlay can help mitigate some of this risk by adding interest exposure, such as through US Treasury futures, to complement the holdings of other fixed income managers. This is a way for plan sponsors to increase and monitor their interest rate hedge ratio in a capital-efficient manner while maintaining allocations to other parts of the portfolio designed to generate growth and improve funded status over time.
For corporate pensions considering liability-driven investing (LDI), the risk mitigation of a completion overlay is hard to ignore. It may be easy to dismiss LDI in the current environment given record-low Treasury yields. But plan sponsors should nonetheless consider making plans now so they’ll be ready to use these tools to reduce pension risk going forward.