In Revisiting Pension Asset Allocation, we share a framework for reducing funding ratio volatility through the management of risk drivers. The two main risk factors for a pension plan are market risk, or adverse outcomes for return-seeking assets, and interest rate risk, or how changes in interest rates adversely impact the relationship between assets and liabilities. Further, we divide interest rate risk into the primary components relative to both the risk-free rate and credit spreads.
Our asset allocation process addresses market and interest rate risk by setting target values for three areas of strategic asset allocation.
1. Return-seeking asset allocation target. The proportion of assets allocated to return-seeking assets has a major influence on long-term risk and return. Exposing a plan to market risk helps to capture the equity risk premium—the assumed return on equities above the risk-free rate—which targets funding ratio improvement over the long term, but higher allocations to return-seeking assets come at the cost of additional risk. Appropriate allocations to return-seeking assets can range from 0% to 70%, and depend on the plan's funding ratio, plan status, participant demographics, and how the plan's financial results correlate with the underlying business of the sponsor.
Pension liabilities are valued using market yields on high-quality corporate bonds and therefore are sensitive to changes in interest rates. A plan manages this risk through a strategy known as liability-driven investing, or LDI. Changes in interest rates can be separated into two components: movements in the underlying risk-free rate and movements in credit spreads. We see a benefit in separately analyzing and allocating assets to manage these risks.
2. Interest rate hedge ratio target. The interest rate hedge ratio reflects how fluctuations in interest rates impact both the plan's assets and liabilities. Plans often look to offset interest rate risk though investment in long-duration Treasury and corporate bonds, as well as derivative securities such as Treasury futures. In Vanguard's view, a plan's interest rate hedge ratio should be at least equal to its funding ratio.
3. Credit spread hedge ratio target. The credit spread hedge ratio quantifies the portion of liability risk resulting from changing credit spreads that is expected to be offset by the liability-hedging portion of the investment portfolio. Plans often invest in long-duration high-quality corporate bonds to protect against credit spread risk. Due to credit spread risk being a lower order risk than interest rate risk, and other factors further explained in the research, our view is that a plan's credit spread hedge ratio can be lower than its interest rate hedge ratio and approximately equal to the interest rate hedge ratio multiplied by the allocation to liability-hedging assets.
The figure below illustrates the transition of a hypothetical plan's asset allocation from return-seeking assets to liability-hedging assets as the plan's funded status improves. During this process, both the interest rate and credit spread hedge ratio increase, and surplus value at risk decreases.
Sample glide path for a hypothetical pension plan