The paper, “CFO Summary on How Funding and Accounting Rules Impact Interest Rate Risk Management,” by SEI Global Institutional Solutions, asserts that plan sponsors now have to do a much better job of limiting funding volatility. That comes in the context of new funding and reporting requirements from the Pension Protection Act (PPA) and new pension accounting mandates from the Financial Accounting Standards Board (FASB), SEI researchers said (See Voice: Working with FASB Accounting Standards and the Pension Protection Act ).
SEI said financial executives have been concerned in light of the new rules with the heightened impact of their company’s plan on their financial statements.
“ As the funding requirements are phased-in beginning in 2008, in order to (effectively deal with the new rules), financial executives must now place a much greater emphasis on understanding the “true” value of the plan’s assets as well as the plan’s overall liabilities on an ongoing basis,” the document said.
SEI said that’s why many companies have been paying more attention to techniques such as Liability Driven Investing (LDI) (See Employers Slow to Implement LDI Strategies , Cover: Corporate Plan Sponsor of the Year: Slow and Steady ) and duration – a measure of the sensitivity of the value of assets or liabilities to changes in interest rates.
The research paper suggests that financial executives could extend the duration of the asset portfolio through direct investment in longer duration assets or through the use of interest rate derivatives such as interest rate swaps.
“By hedging away interest rate risk, organizations can more easily coordinate liabilities and assets to be used in budgeting and operating the plan sponsor’s primary business…,” the SEI document stated. “The other side of the equation in using longer duration assets is that they will no longer be appropriately benchmarked to the typical core fixed income indices. While absolute return of the fixed income portfolio may be one measure to be considered, it is more appropriate to measure interest rate change in the asset pool against the liability.”
According to SEI, use of duration extending asset management tools should be carried out with care to understand that the risk to be measured is the balance of the assets and the liabilities, not the absolute size of the asset pool. Appropriate benchmarks should be chosen to measure the efficacy of the overall pension management strategy, not just the investment strategy, the researchers suggested.