Despite the significant increase in volatility in 2022, corporate defined benefit (DB) plans' funding ratios improved further after rising in 2021. DB funding status reached 111.2% as of November 30, 2022, versus 97.6% as of November 30, 2021.1 This increase reflects the sharp rise in bond yields that has pushed liabilities lower. As a result, pension plans continue to seek to efficiently de-risk and increase allocation to fixed income. However, it is important that de-risking is performed thoughtfully to achieve each plan’s goals.
De-risking is an important strategic tool for plans practicing liability-driven investing (LDI). De-risking carried out through a shift from return-seeking assets (such as equities and real assets) toward liability-hedging assets (high-quality, long-duration fixed income) has been a dominant theme for corporate DB plans over the past decade. However, there are important pitfalls in using standard long-dated indexes to hedge the interest rate movements that could impact the plan’s expected liability stream. These pitfalls could prevent LDI investors from accomplishing their investment goals.
1 Milliman, Bloomberg Finance, L.P., as of December 7, 2022.
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Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
International Government bonds and corporate bonds generally have more moderate short term price fluctuations than stocks, but provide lower potential long-term returns. Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
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