Merrill: DB Sponsors Should Look at Interest Rate Swaps

January 24, 2005 ( - With an accounting shift to a mark to market approach on the horizon, defined benefit traditional pension plan sponsors should adopt a program of interest-rate swaps to help better manage their interest rate exposure.

That was the assertion of three Merrill Lynch analysts in a new research paper, Swapping the Paradigm, which claimed that the mark to market change “is not a question of if, but a question of when (See  Accounting Rulemakers Ponder ‘Mark to Market’ Approach ).”

“We believe this change would mean that DB plan funded status volatility would have a greater impact on company financial statements,” continued analysts Adrian Redlich, Gordon Latter, and Shuaib Siddiqui. “This, in turn, will require that DB plan sponsors explore strategies that effectively manage risks that impact funding levels.”

Part of the Merrill analysts’ argument is that DB plan sponsors need to shift their plan management philosophy. “By swapping our paradigm of traditional thinking, by using a liability-based benchmark to track the relative performance of plan assets to liabilities, this allows for more effective management of funding levels,” the analysts wrote. “We fundamentally believe that a strategy that uses interest rate swaps to match the interest rate sensitivity of assets and liabiilities provides superior net plan performance.”

To illustrate the extent of a DB plan’s interest-rate risk – and help make their case for an interest-rate swaps program – the three Merrill analysts said that a 100 bps drop in rates would mean an increase in plan liabilities of 12% to 15% and asset appreciation of only 1.5%. They said that since a “typical” portfolio hedges about 12% of its interest rate exposure, this kind of decline would drop funding levels by more than 9%.

The analysts contended that a swaps program lowers a plan’s chance of underfunding and lessens volatility. A fully funded DB plan at the beginning of the plan year without rate hedges is four times more likely to be underfunded than a plan with such hedges, they argued.

Not only that, but a swap program allows a plan sponsor to open up more potential liquid and investable assets that can outperform the benchmark as the plan sponsor moves his or her liability benchmark from the long to the short end of the yield curve, according to the Merrill research.

The analysts admit that there’s a long way to go to convince plan sponsors of the wisdom of their swaps-program suggestion. Citing a PLANSPONSOR Magazine survey, Merrill pointed out that fewer than 12% of plans have put in place “disciplined” interest-rate risk mitigation strategies.

The research paper also explores the funding status of a portfolio of 70% equities and 30% fixed income portfolio with interest-rate swaps and argue that such a plan would remain 100% funded even with a 1% rate decline or a 1% rate hike.