Hedge long first: Making your LDI assets work harder

Hedge long first, or HLF, is a category of liability-driven investing strategies that pays more attention to some liabilities than to others.

Specifically, the strategies concentrate fixed-income exposures on the longest-dated liability cash flows first, because they are more financially impactful on the plan and, therefore, the sponsoring company. By hedging those longest cash flows first using various types of strategies, an interesting range of options opens up. One can either reduce surplus volatility (i.e. narrow the range of funded status outcomes driven by interest rate movements), or retain the same surplus volatility but increase expected return.

The case for HLF is based on the idea that not all liabilities are created equal — some represent more risk than others.

In the example shown below, we have broken down a representative plan that has total liabilities of $1,000 and an average duration of 12 years. Each respective 20% of those liabilities is represented by a different color. While each of the five subsets of the cash flows represents $200, or 20% of the total liability, they carry different levels of risk for the plan. The shortest-dated liabilities represent just 2% of the total variance of the liabilities. The longest-dated liabilities represent 44% of the total variance.

Looking at these results, one might wonder why plan sponsors use scarce capital to hedge liabilities that have little financial impact on their plans.

For a given allocation to LDI, many corporate plan sponsors hedge the duration of their liability. However, most plan sponsors do not have 100% of their capital allocated to fixed income. The amount of interest rate risk being hedged is less than the liability in dollar terms. If a plan has allocated 50% to LDI, is fully funded and is hedging the duration of its liability, it is probably hedging 50% of its interest rate risk (called a liability-weighted approach).

Instead, the same plan with a 50% allocation to fixed income can hedge approximately 78% of its interest rate risk if it employs a pure version of HLF where each of the longest cash flows or key rates is hedged first, up to the same level as the liability. By extending duration even further using extended HLF, the plan could hedge up to 100% of its interest rate risk with a 50% allocation to LDI. The amount of interest rate risk being hedged ultimately depends on the amount of surplus volatility the sponsor wishes to reduce, or the amount of surplus volatility the plan sponsor wishes to reallocate because it is hedging more interest rate risk with a lower allocation to LDI and higher allocation to growth assets.

The effect can be material. In representative examples, we estimate the volatility of the plan shortfall could be reduced by roughly 21% under an HLF approach (to 5.9% per annum from 7.5%) or 29% (to 5.3% per annum from 7.5%) under an extended HLF approach. Alternatively our representative plan could increase expected return by roughly 6% (to 5.3% from 5%) or 10% (to 5.5% from 5%) under the HLF and extended HLF methods, respectively, without affecting surplus volatility. This is certainly a different take on the difficult question of if and when to extend duration for a corporate plan!

If investors are seeking to improve funded status by positioning their portfolios for an increase in interest rates or a steepening of the yield curve, they might not want to extend duration by implementing HLF or extended HLF. If they do choose some version of HLF, transaction costs need to be taken into account because there is a limited supply of instruments to achieve an effective hedge at long durations. The longest dated investments in an LDI portfolio tend to be Treasury rather than credit. That means HLF strategies might have the side effect of lowering exposure to credit and, hence, to the credit risk premium.

Even with these considerations, HLF strategies offer a new approach to managing surplus volatility. This might be particularly attractive to plan sponsors today because the inclusion of new mortality tables in annual disclosures has many sponsors looking to make up greater funding shortfalls without adding risk.

Martin Jaugietis is managing director, LDI solutions, and David Phillips is director, risk analytics, at Russell Investments, Seattle.