In setting the investment strategy for a defined benefit plan, a decision must be made regarding the percentage of liabilities to hedge There is no one right answer; different plans have different views dependent on varying circumstances.
We recommend plans set a strategic hedge ratio equal to the plan's funding ratio (i.e., 80% hedge for an 80% funded plan). This minimizes short-term risk, defined as funding ratio volatility. While assuming some investment risks provide incremental long-term returns, interest-rate risk is generally viewed as uncompensated because the future level of interest rates is very unpredictable even for the experts. Rather than focus on a plan's historic hedge levels or current interest rate levels, we recommend plan executives primarily evaluate the plan's investment strategy relative to this strategic hedge ratio target.
Plans may diverge from this ratio to reduce longer-term risks, as various trade-offs and cost considerations are plan specific.
Why hedge liabilities?
Broadly speaking, hedging refers to the allocation of capital to assets that have similar risk characteristics to the plan liabilities. The expectation is that these assets will move in line with a portion of the plan liabilities, helping to dampen funding ratio volatility.
The main contributors to funding ratio volatility are interest rate, credit spread and equity risk. Plan assets can be affected by all three risks, whereas plan liabilities are affected by only two, or maybe better 1 1/2, of these risks: interest rate and credit spread, not credit default, risk. From an investment perspective, taking risks should be considered relative to whether the risk is rewarded in terms of higher expected returns and/or the risk provides diversification benefits within the context of the overall portfolio, including liabilities.
A risk/reward payoff over the long term is generally expected from a plan's exposure to a well-diversified return seeking asset (i.e., equity) portfolio, usually designed to help close the funding gap over a longer period of time. Although this is a source of risk, it is generally considered to be a compensated risk, especially for plans that are underfunded. Many plans may therefore accept the level of risk from their strategic allocation to return-seeking assets, assuming the allocation is appropriately sized in the context of their overall investment strategy.
Pension plans also can reduce risk by reducing this allocation to return-seeking assets, but are likely also reducing expected returns commensurately, which might hinder the plan's ability to close the funding deficit gap. Alternatively, pension plans can also reduce funding ratio volatility by directly hedging the risks that affect the value of the liabilities.
The aim of liability hedging is to reduce the overall risk of the pension plan that arises from uncertainty in future interest rates, typically the largest source of risk for a pension plan.
All else being equal, for an unhedged pension plan, the funding position will deteriorate when interest rates fall, causing the value of the future pension promise to rise.
An underfunded pension plan hurts its core business in numerous ways: lower profits, reduced free cash flow, a lower credit rating and reduced ability to borrow. Funding ratio volatility can force a plan sponsor to contribute cash into the plan when it can least afford to do so. It also puts plan participants' benefits at risk. Absent any high conviction tactical views on the future level of interest rates, why would a plan sponsor want to take on this type of uncompensated, non-core financial risk to their main business?
How much to hedge
The consideration of risks and rewards of any investment decision should include assessment of both short-term and long-term outcomes and how these might evolve over time. Below is an exhibit that shows how different hedge ratios affect two short-term risk metrics without reducing the plan's allocation to growth assets, and shows that setting the hedge ratio equal to the funding ratio, 100% of assets hedged, minimizes funding level risk. Plans wanting to minimize risk of the dollar deficit should hedge 100% of its interest rate risk.
In this simple analysis, we assume that plans are able and willing to use leverage to hedge interest rate risks. Derivatives provide significant flexibility to achieve desired hedge ratios across a range of asset allocation exposures. In the absence of leverage, the amount to hedge is constrained by the plan's allocation to hedging assets to be invested in physical bonds with no derivatives.
Other factors to consider include the longer term implications of hedging for the plan sponsor; the costs of hedging and glidepath framework; the forward curve; and tail risk considerations. It is also important to determine which liability measure to hedge within the solution.
In summary, there is a strong rationale to set the interest rate hedge equal to the plan's funding ratio from a strategic perspective. This hedge level minimizes uncompensated risk due to changes in interest rates and helps plan sponsor manage funding ratio volatility.
Behaviorally, we recommend that plans primarily evaluate the investment strategy relative to this strategic target, rather than focus on where the hedge level has been historically or where interest rates are.
Managing interest rate risk within a well-defined liability-driven investment strategy can help plan sponsors effectively manage funding ratio outcomes and minimize volatility.
Chris Wittemann is senior solutions strategist at Legal & General Investment Management America, based in Chicago. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.