As you are by now aware, an increase in interest rates causes a
decrease in the price of bonds. Given the recent increase in interest
rates, bond prices have of course fallen. Pension funds rely primarily
on bonds in order to fund future payouts to pensioners. You would think
that the fall in bond prices has caused pension fund managers to panic,
but your assumption would be incorrect. While bond prices have fallen in
value, the pension liabilities have fallen in value
as well. In fact, most pension liabilities have fallen more than the
bond prices. The reason has to do with the duration of the bonds and
pension liabilities.
Duration measures the interest rate
sensitivity of an asset or liability for a given change in interest
rates. For the pension liability to fall more than the price of the bond
used as an asset to fund the liability, the duration of pension
liability must be greater than the duration of the bonds used to fund
the liabililty. As the report notes, the funded ratio of a hypothetical pension plan rose to its highest level in 18 months. (For more on duration, check out Excel Master.)
