July 2014

Plan Sponsors Should Consider Extending Duration Even If They Believe Rates Will Rise, Says Cambridge Associates

Defined Benefit Pension Plans Looking to De-Risk Should Not Fear Rising Interest Rates; If They Haven’t Done So, They Should Consider Moving Away from the Barclays Aggregate Bond Index, and Lengthening the Duration of Their Bond Portfolios

BOSTON (July 15, 2014) – Defined benefit pension plans that wish to de-risk should consider lengthening the duration of their fixed income portfolios if they haven’t already done so, even if they believe that interest rates are likely to rise, according to a new paper from Cambridge Associates, the global institutional investment advisor.

Although conventional wisdom says that long-duration bonds should underperform short-duration bonds if interest rates are expected to rise, shifting away from a Barclays Aggregate Bond Index-based fixed income allocation (“Agg”) toward longer-duration indexes may be beneficial in terms of both risk and return. In fact, further delaying action may subject plans to the “Agg drag,” a potential lowering of the expected returns of the overall investment portfolio at a higher level of surplus risk than with a longer-duration strategy, according to Avoid the Agg Drag, a new paper from Cambridge Associates.

“Shifting away from an Agg-based fixed income allocation may make sense even if interest rates begin to rise. Pension sponsors who are reluctant to de-risk until after rates rise may be taking on more risk than they have to,” said Sona Menon, Managing Director at Cambridge Associates and co-author of Avoid the Agg Drag.

The Problems with the Agg Index

The Agg Index acts as a poor hedge for a plan’s liabilities, as it suffers from two structural drawbacks. First, its relatively low duration of 5.5 years makes it less sensitive to interest rate movements than a typical plan’s liability, which can pose a threat to funded status when rates decline, as they have this year. Second, less than a quarter of the Agg Index is invested in corporate bonds, the instruments that best mimic the liability. Many long-duration indexes can be a more effective hedge, as they have a duration closer to a typical plan’s liability and contain a higher proportion of corporate bonds.

Another benefit of shifting to a longer-duration strategy is that it need not require any reduction in growth-oriented assets (e.g., global equity, hedge funds, etc.), so a change in asset allocation is not necessary.

“This is an easy first step to de-risking without having to allocate more dollars to bonds at the expense of growth assets, which have a higher return potential,” said Menon.

Longer Duration: Higher Rates…Higher Returns?

Perhaps the most compelling reason for considering a move away from an Agg-based fixed income allocation in favor of long-duration exposure is that – against conventional wisdom – a long-duration strategy in the face of rising interest rates does not necessarily result in underperformance. In fact, only a sharp and rapid rate increase would lead to underperformance of a long-duration strategy relative to the Agg Index.

To earn a higher total return from a short-duration strategy relative to a long-duration strategy over a given time horizon, rates across the yield curve would need to rise dramatically. If rates rise at a smaller magnitude or a slower pace than what is priced into the curve, a longer duration strategy should outperform a shorter duration strategy.

Moreover, maintaining an Agg-based fixed income allocation and waiting for interest rates to rise has on ongoing cost relative to the liability.

“Because of the currently steep yield curve, the annual coupon yield earned from the Agg is lower than the annual interest expense accrued by the liability. It is essentially a negative carry position for plan sponsors,” says Menon. “That pensions should fear interest rates over all other variables is a common – and potentially damaging ­– misconception. Pension sponsors should consider how they can de-risk despite whatever may happen to rates in the near-term.”

“We know how difficult it is to accurately predict the timing and magnitude of interest rate changes,” says Menon. “Regardless of how and when rates move, a defined benefit plan may be able to achieve benefits from shifting away from the Agg-based fixed income strategy into a long-duration one.”

To schedule a conversation with the author, Sona Menon, please contact Frank Lentini, Sommerfield Communications at (212) 255-8386 /


About Cambridge Associates

Founded in 1973, Cambridge Associates is a provider of investment services to institutional investors and private clients worldwide. Today the firm serves more than 950 global investors and delivers a range of services, including investment advisory, discretionary investment solutions, research and tools (Research Navigatorsm and Benchmark Calculator), and performance monitoring, across asset classes. Cambridge Associates has more than 1,100 employees based in eight global offices in Arlington, VA; Boston; Dallas; Menlo Park, CA; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit