Is it time to increase your coverage ratio?

Torsten Asmus

Sponsors of corporate defined benefit (DB) plans face two primary risks: equity risk and interest rate risk. Equity risk is taken to generate a return, and while there can be volatility, over time this risk has proven to be well compensated. On the other hand, the interest rate risk is unremunerated, which means that we generally do not expect to be paid for taking on this risk over the long term. Sometimes interest rate risk can favor capitalization (for example, when rates go up), while other times it hurts capitalization (for example, when rates go down).

What are the top three ways DB sponsors can improve their coverage ratio?

So why do plan sponsors take on any interest rate risk? Or, in other words, why don’t DB sponsors have much higher interest rate coverage ratios? As we explained A few years agosponsors have three key levers to improve their coverage ratio:

  1. Improve funding status directly through contributions
  2. Increase LDI Physical Allocation at the expense of for-profit assets, or
  3. Increase duration by extending the physical duration of fixed income securities or by using derivatives

The first two levers shown above require either higher contributions or a lower allocation to yield-seeking assets, which could ultimately lead to higher costs for the sponsor. This leaves the third option of extending duration, which is by far the most effective method of improving coverage ratios.

Increasing the duration: the most effective method

While many sponsors have chosen to extend their LDI duration to improve their coverage ratio, the majority could go further. This will better align assets with liabilities and help mitigate volatility in funded status in accounting and (in some cases) PBGC metrics. This is also essential for closed and frozen plans that have become fully funded and seek to maintain their funding without re-contributions. There are strong arguments for this argument regardless of the interest rate environment. So why not extend the duration as much as possible? Some did, but many did not. This could be partly because to extend the duration this far, you will either need to introduce or increase exposure to derivatives such as Treasury futures, or rely heavily on STRIPS. Treasury futures are common in large DB plans as a means of increasing coverage ratios or fine-tuning coverage, but some sponsors may still be hesitant to pursue. STRIPS do not offer the same potential return as long credit due to the additional spread. However, looking at the plan as a whole, this return forgone by giving up credit may be offset by additional return on equity-like assets, which can also help cover the credit component of liabilities. Therefore, in many cases, interest rate hedging can be improved while simultaneously increasing return potential.

A common concern we’ve been hearing for many years is that rates will rise, and when they do, long-duration fixed income will lose big. This may be true for assets in isolation, but for an underfunded plan, the funded position is likely to improve further in this environment (i.e. liabilities will decline more than assets) . Regardless, this concern persisted over the years as rates continued to decline for low records only a few years ago.

So what now? Rates have increased dramatically. Treasury rates hit their lowest level in decades in 2020, but since July 2020 the 10-year Treasury rate has risen more than 300 basis points!

Click on the image to enlarge

10-year Treasury rate since 2000

Although rates may rise further, the probability of entering a recession has been increasing. Recessions come with uncertainty, especially for equity returns. This concern is in addition to the fact that rates typically fall during a recession. The exact impact of this on DB plans will depend on yield curve shifts and liability-specific metrics, but aside from our strategic view of the benefits of interest rate risk hedging, the timing now seems to be good.

The bottom line

If sponsors have been waiting for rates to rise to further extend the duration of their LDI, now is the time to act.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

Sallie R. Loera