In the past, the funded position of a company's benefits program was often referenced only in the footnotes of financial statements. But a recent rule change by the U.S. Financial Accounting Standards Board will make pension plan funding status much more visible – as an asset or liability on company balance sheets. Furthermore, as a company's funding situation changes, for better or worse, that information must now be included on income statements.

Small Change, Significant Effects
The new accounting procedures won't likely have a big impact on investment analysts, who generally carefully weigh plan funding status as part of their company evaluations. But for corporate treasurers, the revised standard means managing the risk that a pension plan deficit could negatively affect company earnings. While some plan sponsors have opted to freeze or discontinue their defined benefit plans altogether, there's another alternative to managing this risk. By lengthening the duration of a fixed income portfolio to more closely match that of your company's payout obligation, plan sponsors can not only reduce their risk, but also potentially increase the returns on their investments.

Long Obligation, Short Duration
While longer duration issues entail greater potential for short-term volatility, the greater risk for long-term investors, such as pension funds, is not accumulating enough to meet future payout requirements. "If you invest in short-term vehicles to fund an obligation that is far in the future, you need to continually roll over your investments, reinvesting proceeds as the security reaches maturity," explained Mark Newlin, managing director, Fixed Income Management. "If short-term interest rates remain low, you might reach the end of your investment horizon without having accumulated enough money to fund your obligation to pensioners." Yet despite potential payout periods that can be 30 years or more, most pension fund fixed income investments have an average maturity of only about seven to 10 years. This mismatch leaves corporations vulnerable to gaps in funding.

Better Match, Less Risk – and Greater Potential Return
By matching the duration of your company's pension investments and payout obligation, you tie the value of your assets to your liabilities, dramatically reducing reinvestment risk. For example, if interest rates fall dramatically in a given year, the present value of your company's future payout obligations will increase just as dramatically. However, if your firm has matched the duration of assets to its obligations, the market value of the investments will also rise by a proportionate amount, leaving the funded position unchanged.

In addition, because the yield curve generally slopes upward, if you increase the average maturity of your portfolio, you generally also increase your average yield. "There are few free lunches in the financial markets, but increasing duration is a rare win-win strategy, said Newlin. "You can reduce your risk with little chance of a commensurate drop in return potential."

Watch the Timing
Despite the multiple benefits to lengthening duration, no investment strategy is entirely without risk. By locking in a long-term interest rate, you face potential opportunity costs of not investing for higher return. For example, today's interest rate on a 10-year bond is approximately 5%. That's low by historical standards, as well as when compared to the average historical return of alternative long-term investments, such as stocks, real estate or hedge funds. In addition, that rate may be lower than the accounting assumptions your company has made about the long-term return of its assets.

Because the level of interest rates will affect your opportunity costs, timing is a critical component of a successful long-duration strategy. Newlin suggests that plan sponsors should carefully examine current interest rates before implementing the change. He continued, "Plan sponsors that lengthen their portfolios when bond rates are 7% or 8% obviously will fare far better than those who lock in at 5%. However, there are no guarantees that rates will rise anytime soon. For that reason, companies whose funded position – and now, their financial statements – would suffer from an environment of low rates combined with falling stock prices might want to consider lengthening sooner than later."

If you would like more information about how a long-duration strategy may be able to help your company address the challenges of new pension plan accounting rules, please contact Mark Newlin.

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