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.