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!