Managing Pension Liability Credit Risk: Maintaining a Total Portfolio Perspective

Abstract

Widening corporate bond spreads have caused a dislocation between corporate-bond-based pension discount rates and the rates of commonly used interest rate hedging tools. As a result, widening spreads have brought the issue of how to manage liability credit risk to the forefront for plan sponsors. Whereas managing liability interest rate risk via interest rate swaps and/or Treasuries is relatively straightforward, managing liability credit risk is more challenging for three reasons: 1) the credit component of liability returns are not investable, 2) no capital-efficient risk management tool exists to hedge liability credit risk, and 3) the connection between credit spreads and the returns of common risky assets (i.e., equities) is relatively reliable, especially during periods of economic stress when the values of risky assets typically fall as credit spreads widen. In order to construct efficient liability-driven solutions and avoid poor funding ratio outcomes, it is thus essential to view liability credit spread risk from a total portfolio perspective inclusive of risky assets. Meder recommends that, from a long-term policy perspective, plan sponsors should generally avoid credit risk in the liability hedge. From a tactical perspective, however, adding credit risk to the liability hedge when credit spreads are wide and expected to narrow can improve funding ratio outcomes, but the amount of credit risk taken must be appropriately scaled to the total portfolio.