Pension plan managers should carefully evaluate forward interest rates in an effort to ensure long-term success.
Interest rates can have a significant impact on a corporate pension plan. Plans invest assets to pay for benefits in the future, benefits that are valued by discounting projected liability cash flows to a present value using market yields.
Liability-driven investment (LDI) seeks to implement investment strategies that satisfy appropriate risk and reward goals for a given plan sponsor. A key aspect of such a strategy relates to the relationship of interest-rate exposure in assets and liabilities.
If rates rise more than forward rates predict, then a plan will win by having less interest-rate exposure (dollar duration) in assets as compared to liabilities. If they rise less than forward rates indicate or they decrease, the plan will lose by having less interest-rate exposure in the assets than in the liabilities. If the plan has the same amount of exposure in each, the change will not impact the plan.1
Since interest rates play such a meaningful role in assets and liabilities, many investors are tempted to predict where interest rates are headed in the future, even though that prediction opens the possibility of volatility and poor outcomes. When evaluating future interest rates, however, one must consider forward interest rates as opposed to current interest rates.
Forward rates: A collective best guess?
Forward rates show the implied yield curve in the future based on current yields. For example, an investor should be indifferent when it comes to investing in an 11-year bond today as opposed to investing in a one-year bond today and reinvesting the proceeds in a 10-year bond one year in the future. The entire market is responsible for the shape of the yield curve and the forward rates that it implies because those are the yields at which the market is trading bonds. Some managers try to take positions based on whether they think rates will increase or decrease. In an efficient market, we would assume those yields and forwards represent a collective best guess from all market participants of where rates will be in the future.
The chart below illustrates how well the market predicts future interest rates. In this chart, we’re examining spot and forward rates (from 1 to 12 months) for a 10-year zero coupon bond. The forward rate is represented by the green curves, which start at the end of each year and represent what’s expected based on the spot yields at that time over the following year.2
The chart examines Treasury yields, although US corporate pension liabilities are normally valued using corporate curves. Similar charts can be created for other maturities and for corporate curves instead of Treasury curves—similar outcomes occur in those cases, although the actual numbers vary. Additional charts have been appended.
10 Year Spot versus Forward [US(Govt)]
Sources: Parametric, ICE, 8/27/2021. For illustrative purposes only. US government forward spot calculated internally.
This chart offers several intriguing insights to explore.
First, forward rates a year out are seldom accurate predictors of actual interest rates in the future. The ending points of the green curves are commonly far from where the blue curve shows spot rates. What is priced into the market today isn’t necessarily providing solid information about where the market’s heading.
Second, if the yield curve is sloping upward, the forward rates are going to be above current rates. In other words, the market expects yields will rise going forward, as depicted in almost all the green curves in the chart. This is important because, if you believe rates are going up, they need to go up more than forward in order to win on that bet. If they stay below the forward rates, you would have been better off hedging. More fully hedged plans won’t see a change in funded status that is as large and are less affected by yield changes than less hedged plans.
Finally, the spot rates exhibit quite a lot of volatility compared to the forward rates. Over the course of a year, the spots have moved in interesting patterns. Sometimes the spots have simply exceeded forward rates from beginning to end of year—sometimes the opposite. In other years, spots have bumped significantly higher only to revert to lower levels—sometimes below the forwards. Again, in other years it’s the opposite. The direction and speed at which rates change turn quickly. Taking a specific position on rates would require not only a strong conviction on future yields but also that those convictions are tested daily, that they are correct, and that they can be acted upon quickly.
Learn what curves say about future LDI yields
Similar charts can be created for other maturities and for corporate curves instead of Treasury curves—similar outcomes occur in those cases, although the actual numbers vary.
2 Year Spot versus Forward [US(Govt)]
Sources: Parametric, ICE, 8/27/2021. For illustrative purposes only. US government forward spot calculated internally.
30 Year Spot versus Forward [US(Govt)]
Sources: Parametric, ICE, 8/27/2021. For illustrative purposes only. US government forward spot calculated internally.
2 Year Spot versus Forward [USDCORPAAA-A3-MKTWGT(Corp)]
Sources: Parametric, ICE, 8/27/2021. For illustrative purposes only. US government forward spot calculated internally.
10 Year Spot versus Forward [USDCORPAAA-A3-MKTWGT(Corp)]
Sources: Parametric, ICE, 8/27/2021. For illustrative purposes only. US government forward spot calculated internally.
30 Year Spot versus Forward [USDCORPAAA-A3-MKTWGT(Corp)]
Sources: Parametric, ICE, 8/27/2021. For illustrative purposes only. US government forward spot calculated internally.
The bottom line
It’s tempting to try to predict the direction of interest rates. At the end of the day, forward rates demonstrate that smart investors don’t collectively predict yields well. Making a call on interest rates should be done with caution. In a corporate pension plan, outcomes can be significantly different than what the market is predicting. Risking additional volatility to funded status by taking unnecessary positions requires immense confidence in your convictions.
1 This assumes the same exposure across the entire yield curve, as differences across the yield curve may result in differences in returns, even if the total durations are the same.
2 We’ve chosen 10 years because it’s a commonly referenced benchmark rate and the interest rate exposure isn’t too dissimilar to a typical corporate pension plan’s liability.
