Corporate pension plan liabilities are sensitive to changes in long-term interest rates, which create a key risk for the sponsor’s balance sheet and other financials. Like bond prices, pension liabilities shrink as interest rates rise. Conversely, as interest rates fall, pension liabilities increase and could put pressure on pension financials. Plan sponsors have sought ways to manage this risk utilizing liability driven investment strategies.
Hedge Ratio Explained
To offset unexpected swings in pension liabilities due to changes in interest rates, plan sponsors typically set aside a portion of their assets in fixed income. The conventional measure for the level of interest rate protection provided by the portfolios is called the hedge ratio which is the dollar value of interest rate sensitivity of the plan’s portfolio divided by the dollar value of the interest rate sensitivity of the plan’s liabilities. A hedge ratio of 100% means that the plan is expected to be fully insulated to changes in interest rates. Plans experience various degrees of hedging which is dependent on the portion of the assets in fixed income, the duration and structure of the fixed income, as well as the plan’s funded status.
Consider Hedge Effectiveness
Not all hedge ratios are equal. The total hedge ratio outlined above assumes that interest rates move up and down in a parallel fashion all along the yield curve. Rates at the front end are primarily controlled by the Federal Reserve through monetary policy, while long-term rates from ten to thirty years out are driven by other economic factors. The yield curve can change shape and yields at the front end, the middle, and the long end rarely move in sync. To avoid unexpected pension financial outcomes, it is important to understand how effective the hedging strategy is not just in aggregate but at all parts of the curve.
Duration Positioning: Sample Risks
Fixed income duration < liability duration: Plans that implement a core bond strategy, where duration of fixed income is lower than duration of liabilities face the risk of funded status falling when interest rates decline. While these plans benefit more when rates are rising, we caution plan sponsors against implementing strategies that perform in only one type of rate environment.
Fixed income duration = liability duration: Some plans implement fixed income strategies that target matching the duration of the liabilities. Depending on the implementation, a plan could see over- or under- hedging in certain areas of the curve if the fixed income investments utilize bond funds that are not designed for pension liabilities. This type of hedging will result in unexpected outcomes when the shape of the yield curve changes. The best way to avoid this risk is to build a custom individual bond portfolio that fully aligns with the liability profile.
Fixed income duration > liability duration: One approach to manage interest rate risk is to purchase bulk duration at the long end of the yield curve through Treasury STRIPS with durations longer than 15 or 20 years. Some plans use this approach to increase hedge ratios while freeing up capital for riskier (equity-like) assets. These strategies (often called “capital efficient hedges”) sacrifice the discipline of hedging all points on the yield curve and exposes the plan to undesired outcomes if long rates increase sharply. Plans with this strategy (with hedge ratios sometimes above 300% at the long end) experienced negative funded status outcomes in years like 2022 where rates increased sharply, and equities declined. Additionally, credit exposure is difficult to achieve while targeting ultra-long durations and plans may give up important yield to keep pace with liability growth.
Guiding Philosophy
When building a fixed income portfolio to manage interest rate risks, a portfolio that is neutral to the interest rate environment creates reasonable outcomes for plan sponsors. A rate neutral strategy is one that not only targets the liability duration but has the same target across the yield curve. This precision can be implemented by purchasing individual securities within a separately managed account to obtain the proper exposure at all points on the yield curve. Plan sponsors may seek to increase duration beyond the pension liabilities for more interest rate protection; in those cases, maintaining a constant target hedge across the curve creates the most predictable pension financial outcomes.
