Immunization of Pension Funds and Sensitivity to Actuarial Assumptions: Comment

Abstract

A recent article by Keintz and Stickney (K-S) [5] outlines a bond duration method for immunizing pension plans from market rate risk. The authors show how unexpected alterations in market rates of return can cause offsetting changes in pension assets and liabilities. By employing Macaulay's bond duration formula, K-S demonstrate how these opposing balance sheet changes may protect a pension plan from random market rate movements. Their research should prove quite useful in managing pension funds where the investment instruments have known maturities. Some pension plans, though, may desire to invest in corporate bonds where call features could alter maturity structure unexpectedly. K-S raise the issue of the effect corporate bonds with callable features could have on duration. The K-S technique relies to some extent on the pension manager matching the maturity structure of investment assets with fund liabilities.' A call provision allows the borrower to redeem bonds before maturity and thus may impose uncertainty on the length of the asset holding period. Many corporate bond issues will include call privileges which permit early redemption.2 Ostensibly the purpose of the call feature is to provide the corporation with the chance to refinance their bonds when interest rates are lower than when the bonds were originally issued. A bond call provision subjects the investor to the risk of redemption at a time of low interest, thus reducing overall investment yield and uncertainty as to when bond proceeds are payable. Most investors protect against this type of interest rate risk by requiring a higher yield on callable issues. However, the uncertainty with respect to maturity structure of callable issues is one over which the investor has little control. Figure 1 depicts the type of situation faced by the investor in callable securities. Condition A prevails as long as market interest rates during the call period are above the effective yield on the bond. Condition B necessitates