The level of interest rates will always be a critical factor in the health of a pension plan. The interest rate factor poses a particularly insidious danger because it often operates in a counterintuitive fashion. The highly visible effects of rate movements on the asset side tend to carry more “perceptual” weight than their less frequently noted (but nonetheless significant) impact on the liability side. Lower—not higher—rates represent one of the most serious threats to pension plans.
This may be seen if one looks at a plan’s “surplus function”—the excess (deficit) of the plan’s asset value over (under) the present value of its liabilities. The present value of liabilities is extremely sensitive to interest rate movements; plan liabilities generally have durations well in excess of eight years. The asset side of the pension equation is less sensitive; bond durations have averaged about 4.16 over the past six years, while the equity durations have averaged only 2.29. When interest rates fall, the present value of pension liabilities will tend to rise, and to rise faster than corresponding movements in stock and bond prices; the plan’s surplus position will be vulnerable to significant erosion.
The wider the gap between the duration of a plan’s assets and the duration of its liabilities, the more vulnerable the surplus function will be. Given the relatively short durations of equities, increasing a portfolio’s commitment to stocks will increase surplus volatility. In fact, even the 60 per cent equity, 40 per cent bond allocation of the typical pension plan exposes it to severe surplus risk; such a plan that was fully funded in January 1981 would have seen its funded status decline to 69 per cent by June 1986, i.e., a deficit of 31 per cent relative to the new level of its liability. Fortunately, control of portfolio surplus risk can be improved by using the portfolio’s bond component to counterbalance duration shortfalls resulting from substantial equity weightings.
