Your Complete Guide to Index Investing with Dan Bortolotti

How Pension Funds Think About Bonds

2014-03-14T11:15:12+00:00March 14th, 2014|Categories: Bonds|18 Comments

With the bond market up about 3% year-to-date, the bears have been growling less than usual. But I still get a steady stream of email from readers who think bonds “make no sense anymore” because they have low yields and will fall in value if interest rates rise. However, if you’re a pension fund manager your opinion of bonds is probably different.

Before we go further, let’s acknowledge that a pension fund isn’t the same as your RRSP. Institutional investors have an indefinite time horizon, as well as access to far more investment options than you and me. Yet retail investors can learn a lot from the smart money like the managers of the Healthcare of Ontario Pension Plan. (Hat tip to Raymond Kerzérho, director of research at PWL Capital, for pointing me to the HOOPP strategy.)

It’s not about the income

HOOPP uses what it calls a “liability driven” investment approach, which involves constructing two separate portfolios with different goals. The first is the Return Seeking Portfolio, and it includes primarily Canadian and international equities, as well as a number of active strategies. The second is called the Liability Hedge Portfolio, and it is primarily made up of nominal bonds, real return bonds and direct-held real estate.

This latter portfolio is “designed to hedge the major risks of the liabilities—namely, inflation and interest rates—and utilizes assets which exhibit behavior similar to that of the Plan’s liabilities.” Notice what’s missing from that description: the word income.

Retail investors tend to think of bonds (and real estate, for that matter) as income investments. Many have abandoned investment-grade bonds in favor of high-yield bonds, dividend paying stocks and preferred shares because these alternatives offer higher yields, and potentially even higher total returns. But this misses the point. There’s a reason bonds are not in HOOPP’s Return Seeking Portfolio: their role is not to deliver income or high returns, but to manage risk.

Adding bonds to an equity portfolio lowers its overall volatility, but that’s not the kind of risk management we’re talking about here: after all, pension managers are not skittish retail investors, so volatility isn’t a big concern. They are more worried about the risk their fund will fail to meet its future liabilities.

Rising rates reduce your liabilities

Which brings us to the next insight. In the financial media, rising interest rates are presented in a relentlessly negative way. But if you’re a pension fund manager—or long-term investor who thinks like one—rising interest rates aren’t met with fear and loathing.

Pension funds estimate their future liabilities (the payouts they will make to retirees) using a discount rate based on the expected return of the fund’s assets. When the discount rate increases, the fund’s liabilities decrease, which is a good thing. But low interest rates on bonds lead to lower discount rates, which leaves pension funds with greater liabilities.

The point is that interest rates affect both sides of the investor’s balance sheet, which is why HOOPP manages that risk by maintaining a strategic allocation to bonds. As the managers write, “increases and decreases in the Plan’s pension liabilities are offset by gains and losses on the Liability Hedge Portfolio.”

In 2013, for example, the Liability Hedge Portfolio lost $1.44 billion because a spike in interest rates drove down the prices of its bond holdings. However, those rising rates mean higher expected returns going forward, so the fund raised its discount rate by 25 basis points. As a result, its future liabilities fell by about $1.5 billion, more than offsetting the loss in the portfolio’s value. The opposite occurred in 2012, an outstanding year for bonds. That year the Liability Hedge Portfolio rose in value, but the fund managers had to lower their discount rate by 0.30%, which caused its future liabilities to increase.

The perspective of a pension fund manager can help you understand the role of bonds in your own portfolio. Yes, bonds have low yields and they will fall in price if rates go up. But HOOPP’s strategies can help you appreciate that they still belong in a balanced portfolio, and see rising rates as an opportunity rather than something to fear.


  1. Brian March 14, 2014 at 9:01 am

    I asssume that they are constantly buying actual bonds and holding them to maturity rather than buying bond funds.

  2. Canadian Couch Potato March 14, 2014 at 9:20 am

    @Brian: Institutional investors get much better pricing on individual bonds and they don’t need to hire external managers, so that makes sense. But it doesn’t change anything important. Whether you hold individual bonds or bond funds, your interest rate exposure is the same.

  3. Bryan Kelly March 14, 2014 at 9:59 am

    Excellent post and a very helpful read for many investors. You have clearly explained a role of bonds not well understand by most people. Thanks for presenting a clear and well written explanation.

    I will tweet it out to my followers.

  4. Chris March 14, 2014 at 10:27 am

    I’m not sure I understand the premise of this article. The reason the discount rate goes up when interest rates rise is *because* the portfolio is bond-heavy. It’s essentially tautological — it’s not an argument for holding bonds.

    As an unrelated point, I’m not sure I would classify active pension fund managers as “smart money”. If they were smart money, they would be running indexed portfolios.

  5. Richard March 14, 2014 at 11:20 am

    This perspective seems similar to the traditional idea that as long as your time horizon exceeds the duration of the portfolio, rising interest rates will benefit you and falling interest rates will hurt you. Most bonds would shorten the duration of an investor’s portfolio.

  6. Canadian Couch Potato March 14, 2014 at 11:28 am

    @Chris: There are two related arguments, and I probably could have done a better job of making them explicit:

    1. Bonds are not in the portfolio for income: they are risk management tools. Therefore substituting other securities with high yield but more risk (high-yield bonds, dividend stocks) is a poor strategy.

    2. Investors in the accumulation stage don’t need to fear rising rates, because the short-term drop in the bond holdings also results in a higher expected returns for new contributions.

    Hope this is clearer.

  7. Craig G March 14, 2014 at 12:15 pm

    Hi Dan,

    Great post as always; as someone in the early accumulation stage I appreciate the insight into the role of bonds; I understood the benefit of decreasing portfolio volatility but it is nice to see its role strategically explained so well, particularly its role in an environment of likely increasing interest rates. The inevitable interest rate rise doesn’t appear to be so inevitably close anyways, in fact we are hearing more and more about potential drops.

    I have now been using your couch potato portfolio for 3 years and I am extremely happy with both it and this blog’s ongoing help in educating me and also reassuring and reiterating the benefits of the portfolio strategy.


  8. Canadian Couch Potato March 14, 2014 at 1:43 pm

    @Craig: Thanks for the great feedback!

  9. jamie March 14, 2014 at 6:00 pm

    I agree whole heartedly with Bryan Kelly above. But sadly I have no followers to tweet.

  10. Andrew March 15, 2014 at 12:25 am

    It’s not very clear what the connection is between (A) what the fund managers decide their discount rate is, and (B) the present value of benefits they will have to pay out to retirees in the future (their liabilities).

  11. Nathan March 15, 2014 at 1:17 am

    @Chris: In theory higher rates increases the expected return of the equities portfolio as well, since since the equity risk premium should remain roughly constant. (In practice the degree of correlation fluctuates wildly and has gone negative for decades, but in theory higher rates raise expectation all around.)

  12. Oldie March 15, 2014 at 4:11 pm

    @CCP: You said “There’s a reason bonds are not in HOOPP’s Return Seeking Portfolio:” and later “pension managers are not skittish retail investors, so volatility isn’t a big concern.”

    The year-to-year emotional feelings of the managers aside, would there not still be a practical advantage to dampen volatility, even in the Returns portion of a fund like HOOPP? If they don’t have bonds, do they have any income asset at all? If not, then is it correct that they are quite content to let the year-to-year value of this portion fluctuate wildly, calculating that they will not have to draw on this portion to meet their ongoing liabilities until beyond the 15 year horizon when profits are much more likely, bordering on certain, to be in the strongly positive zone? Or do I misunderstand their strategy?

  13. PeterH March 17, 2014 at 6:51 pm

    Re: “But if you’re a pension fund manager … rising interest rates aren’t met with fear and loathing.” I think there may be a “First Law of Fear and Loathing Dynamics” at work here, at least for defined benefit pensions that are not fully indexed. As interest rates and inflation rise, the fear and loathing flows from the pension fund manager to the pensioners, the latter seeing a drop in their inflation-adjusted income.

  14. Andrew March 19, 2014 at 7:02 pm

    This is an interesting post. I like the HOOPP Return Seeking and Liability Hedge idea.

    These particular ideas contrast with Zvi Bodies “Escalating Life Annuity” “floor income” idea where you save in bonds what you need to cover your basic necessary expenses and sort of regard equity return as a bonus that can be used to boost standard of living. He talks about using real return bonds especially as they inflation hedge and then deploy long term equity index call options to harvest any premiums and use that money to buy more bonds. In this way you secure a given, and potentially rising, floor income over time and the bonds are the source of that income. It sounds simple but in practice its not something I would want to do for a lot of reasons.

    But that line of thinking and this post makes me consider why the total return approach matters and how long term thinking is needed if long term objectives are required.

  15. Sean Cooper, Freelance Writer and Blogger March 21, 2014 at 6:22 pm

    Excellent post, Dan! I guess you were listening to Rob Carrick at CPFC13 when he mentioned pensions are an under-covered topic in the blogosphere. Your article was very well written – maybe you should come join me in the pension industry one day.

  16. Peter March 22, 2014 at 3:37 am

    Love this site!

    Slightly off topic, but am I right to be thinking about my future pension in the same way as a bond holding?

    I have earned an inflation adjusted pension which will represent about 1/3 of my anticipated retirement income needs when I reach 62. The pension source is at virtually no risk. So have have been considering that as part of my total investment portfolio for planning purposes- effectively thinking of it as a safe income investment making about 33% of my holdings (close to the Global Potato).

    As a result my other investment holdings are all individual equities and ETFs (50% US, 25% CDN, 10% Developed, 10% Emerging, 5% cash). With about 10 years still to go before retirement, do I still need to think about additional bond holdings as well or is the safe indexed pension income a reasonable replacement of bond holdings as a risk mitigator?

  17. Canadian Couch Potato March 22, 2014 at 8:24 am

    @Peter: A great question. The pension will have a big impact on the asset allocation decision, but it’s not as straightforward as treating it like a fixed income holding. First, if it represents 1/3 of your retirement income needs, that does it mean it is equivalent to 1/3 of your overall portfolio value. There is actually no direct relationship between those two numbers. Even if there were, how could you ever rebalance the portfolio? A pension does not behave like a bond portfolio in any meaningful way.

    Financial planners address this question in a different way. They simply look at your expected income in retirement (including the pension, but also part-time employment and government benefits) and see how much you will need to rely on personal savings to make up any shortfall. Then they determine the target rate of return for those personal savings and decide on appropriate asset allocation that way.

    The interesting thing is that having a solid pension allows investors to take far less risk with the personal savings, because the portfolio doesn’t have to work as hard as it word for someone without a pension. That means they can afford to hold more fixed income, not less. At the same time, however, it gives them the luxury of taking more equity risk if they want to, since a market downturn would have less impact on their retirement.

    In Larry Swedroe’s language the pension decreases the need while also increasing the ability to take risk:

  18. Peter March 22, 2014 at 8:36 am

    You are right. There is no direct connection. I was just thinking of the endpoint. I need X amount per month in income for my plan. 10 years out, at least 30% of my investments should be in Bond type assets to mitigate the potential risk of the rest. And the pension takes out 30% of my risk.

    Interesting that to think it would actually be an argument for less risky equities in the rest of the portfolio! Never thought of it that way before.

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