John White explains why understanding duration can help you better understand your portfolio

Last month, I mentioned I would expand on the term ‘duration’, currently one of the investment industries buzz words, since duration attempts to measure how sensitive a bond’s price is to changes in market interest rates. With CPI double the Bank of England's 2% target and recent Monetary Policy Committee (MPC) minutes confirming a third member (MPC is nine members in total) has joined Andrew Sentence's 'increase interest rates now' camp, it is increasingly likely we may face rate increases as soon a May 2011.

The good news for trustees is that if you calculate the duration of your scheme’s liabilities and then match that duration figure with your bond portfolio (immunise), any fall in your bond portfolio’s asset value should be balanced/matched with the con-sequent reduction in liabilities. This exercise is something your actuary or indeed RSM Tenon can help you with. As we all appreciate nothing in the world of defined benefit schemes is an exact science, but completing this exercise will ensure the divergence of your bond portfolio from your liabilities is kept to a minimum, and indeed illustrates to any interested outside parties that trustees are taking their duties seriously and acting proactively to protect scheme members.

The basic principle of duration is to calculate the present day value of the bonds’ capital and income stream. Those of you with a finance leaning, may well understand this principle from completing Net Present Value calculations and appreciate immed-iately how this could help the scheme. For those of you without that benefit, you will understand that receiving £1,000 today is more beneficial than receiving £1,000 in ten years’ time and duration simply uses this principle to calculate the time weighted value of your capital and income stream. Typically, pension scheme liabilities are long-term, so expect to allocate to long gilts or long corporate bonds, depending on how your liabilities are valued.

The message, I would like to purvey from this month’s article is;

- If interest rates rise, this is likely to adversely affect the capital values of your bond portfolio

- Lower bond capital values mean higher yields and therefore lower liabilities

- If you complete a duration calculation then you will be best placed to balance these changes and immunise your scheme from shifting liabilities.
With modern systems and calculators, what sounds like an onerous task can be completed relatively simply by experienced advisers, and trustees will be in a position to take those proactive steps to protect scheme members' income within a relatively short-time frame.

John White is head of financial management at RSM Tenon

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