Article from:

Pension Section News

September 2013 – Issue 81
 Duration and Convexity for Pension
Liabilities
By Martin McCaulay

F
ormulas for duration are good ap- Modified Duration
proximations for pension liabilities Modified Duration is a measure of the sensi-
with small changes in interest rates. tivity of a bond’s price to interest rate move-
Considering the volatility in interest rates, it ments. Modified Duration is the first deriv-
is more accurate to use duration with a con- ative of how the price of a bond changes in
vexity adjustment. In most cases, the con- response to interest rate changes. Taking the
vexity adjustment results in a lower duration derivative and adjusting for the number of
for rate increases and a greater duration for payments per year simplifies to the follow-
Martin McCaulay, FSA, EA, rate decreases. ing relationship between Macaulay Duration
MAAA, FCA, is an actuary with annual coupons and Modified Duration.
at the U.S. Department of Estimating Changes in
Energy in Washington, D.C. Liabilities Modified Duration =
He can be reached at Martin. Similar to bonds, pension liabilities have an
McCaulay@hq.doe.gov. inverse relationship to interest rates. An in-
terest rate decrease will increase liabilities,
and an interest rate increase will decrease Effective Duration
liabilities. The amount of the increase or de- Effective Duration is used to price bonds
crease can be estimated using the duration with options. Effective Duration approxi-
of the liabilities. To apply the formula for mates the slope of a bond’s value as a func-
duration to pension liabilities, for every 100 tion of interest rate movements taking the
basis point (bp) change in interest rates, the difference in the bond’s value (V) for chang-
liability changes by duration divided by 100 es in the interest rate (i) by an equal amount
in the opposite direction. (x = δi) in both directions, and dividing by
twice the original value times the interest
The typical pension plan has a duration of rate change in each direction.
about 15. Considering convexity, the typical
pension plan has a duration that is less than
15 for interest rate increases and greater than Effective Duration =
15 for interest rate decreases. The duration
for active participants is typically longer
than the duration for retired participants.
The duration for the Normal Cost (NC) is Pension liability duration is measured using
typically longer than the duration for the Ac- the formula for Effective Duration, substi-
tuarial Accrued Liability (AAL). tuting the liabilities (L) for the bond’s value
(V).
Macaulay Duration
The original formula for duration that was Duration =
developed in the year 1938 by Freder-
ick Robertson Macaulay is a measure of a
bond’s weighted average cash flows, using
Duration Example
yield (y), the time period (t), the number of
time periods (n), the annual coupon payment
(C), the maturity value (M), and the pur- Interest Rate Liability
chase price (P). 4% $1,160,000
5% $1,000,000
6% $860,000
Macaulay Duration =

18 | PENSION SECTION NEWS | SEPTEMBER 2013

Duration = To include the convexity adjustment, the du-
ration is adjusted by the convexity times the
interest rate change.
To apply the formula for duration to pension
liabilities, for every 100 basis point (bp) Convexity Example
change in interest rates, the liability chang- (using the liabilities above in millions)
es by about 15% in the opposite direction.
A 100 bp increase results in a new liability
equal to 85% of the original liability. A 100
bp decrease results in a new liability equal to Convexity =
115% of the original liability. Illustrative Examples of Pension Duration
The liability change should be based on a with the Convexity Adjustment
compounded change rather than a simple The following formulas illustrate how mak-
change. Using compounding with a duration ing the convexity adjustment to duration re-
of 15, a 50 bp increase results in a new lia- sults in a lower duration for rate increases
bility equal to 92.20% of the original liabili- and a greater duration for rate decreases.
ty, based on the square root of 85%. A 50 bp
decrease results in a new liability equal to Duration – Convexity =
107.24% of the original liability, based on
the square root of 115%.

Estimates of duration also hold for yields

outside of the corridor used to calculate the
duration. Using the example above, a 200
bp increase results in a new liability equal to
72.25% of the original liability, based on the
square of 85%. A 200 bp decrease results in
a new liability equal to 132.25% of the orig-
inal liability, based on the square of 115%.
Convexity Duration + Convexity =
The traditional formula for pension duration
does not consider convexity. Convexity is
equal to the second derivative of the change
in liabilities for changes in cash flows. In-
terest rate decreases generally cause great-
er changes in liabilities than increases.
Duration with a convexity adjustment can
be used to provide a better estimate of the
change in liability when there is significant
volatility. Pension liability convexity can be
approximated using a formula with the same
variables as the formula for duration.

Convexity =

SEPTMEBER 2013 | PENSION SECTION NEWS | 19

 Duration with Convexity Adjustment ities, and the decrease of 14% in liabilities
Example for the interest rate increase from 5% to 6%
is consistent with the decrease in liabilities
(using the liabilities above in millions) from $1 million to $0.86 million. Using dif-
ferent durations for increases and decreases
To illustrate how the formula for duration
in rates improves the accuracy of estimates
with the convexity adjustment might be ap-
compared to using the same duration for in-
plied to pension liabilities, with a duration
creases and decreases.
of 15 and a convexity of 100, the duration
with the convexity adjustment would equal Negative Convexity
15 plus or minus 100 times 1%. The adjust-
ed durations are 16 and 14. In this illustra- Figure 1: Graph of Negative Convexity
tive example, for every 100 basis point (bp)
Negative convexity when interest rates fall
decrease in interest rates, the AAL increases
by 15% plus 100 times 1% squared, or a to-
tal of 16%. For every 100 basis point (bp)
increase in interest rates, the AAL decreases Bond with positive convexity
by 15% minus 100 times 1% squared, or a
total of 14%.

Duration for Bond with negative convexity

Rate Decreases =

Bond yield
Duration for
Note: This fugure is an Illustration only and is not
Rate Decreases = intended to represent a specific mathematical relationship.
Source: Vanguard.

The price/yield relationship for most

bonds is convex. If the graph is concave,
the relationship has negative convexity,
Duration for as shown in Figure 2 above. Most call-
Rate Increases = able bonds, mortgage backed securities
(MBS), and asset backed securities have
negative convexity at low rates due to the
imbedded options. When rates decrease,
Duration the price will not increase as rapidly as
for Rate non-callable bonds. At high interest rates,
Increases = bonds with call options have positive con-
vexity similar to bonds without call op-
tions.
In the example, the increase of 16% in li- Key Rate Duration
abilities for the interest rate decrease from The duration calculations presented here
5% to 4% is consistent with the increase are useful for parallel yield curve shifts
from $1 million to $1.16 million in liabil- and interest rate changes. Key rate dura-

20 | PENSION SECTION NEWS | SEPTEMBER 2013

tion considers the sensitivity of a liability’s
movement to different parts of the yield
curve. When different rates move in differ-
ent ways, key rate duration is more accurate.
Key rate duration calculations require build-
ing a yield curve.
Summary
Duration and convexity provide a risk met-
ric for pension plan sponsors. The formula
for Effective Duration can be used to esti-
mate the value of pension liabilities at dif-
ferent interest rates. A convexity adjustment
should be applied to reflect the fact that the
pension liability increase for a decrease in
interest rates is greater than the pension li-
ability decrease for an increase in interest
rates. There will be a lower duration for rate
increases and a greater duration for rate de-
creases.

On the Research Front

NEW RESEARCH: EMBEDDED OPTIONS

Embedded options in pension plans play an increasing role in estimating pension liability values.
With the credit interest rate floor of a cash balance plan as a model, this research, authored by Kailan
Shang, Jen-Chieh Huang, and Hua Su, uses three valuation and risk analysis approaches to explore
the existing techniques to value embedded options on an economic basis.  In addition, several tools
were built with comprehensive structures and documented implementation processes. The tools pro-
vide functions like economic assumption calibration, economic scenario generation (ESG), scenario
validation and option value calculations using the three approaches.

SEPTMEBER 2013 | PENSION SECTION NEWS | 21