A Fixed Income Strategy to Combat Interest Rate Risk

In its report, “Myth Busting: It May Be Possible to Reach DB Plan Objectives Regardless of Interest Rates,” Principal notes that fixed income allocations are closely tied to interest rate levels, but no one can accurately predict whether they will rise or fall. This uncertainty can leave defined benefit plan sponsors open to unnecessary risk and potentially higher cost.

The analysis covered by the report finds a combination of core and very long bonds that match a plan’s liability duration comes out on top in a significant percentage of interest rate scenarios.

The report authors modeled three fixed income strategies in three interest rate scenarios—with rates rising, falling or staying the same—over a 10-year period. The strategies were evaluated for the impact to funded status and total accounting cost.

“Contrary to conventional wisdom, our analysis finds that a middle approach to bond duration will, under a broad range of economic outcomes, lead to the best combination of the lowest consistent cost, the least volatility and the highest return,” says Barry Young, consulting actuary of retirement and investor services at The Principal, based in Des Moines, Iowa. “Instead of basing fixed income strategy on an estimate of where interest rates will head, plan sponsors could use this bond duration approach to meet objectives in any interest rate environment.”

He adds: “These findings are a call to action for defined benefit plan sponsors and their financial professionals to evaluate and maybe modify their fixed income strategy.”

More information about the report can be found here.