Extra credit for corporate plans: Advanced topics in LDI implementation

As more corporate defined benefit (DB) plans find themselves in or nearing a fully funded position, they are beginning to brush up on ways to refine their liability-hedging allocation. The goal of that allocation, as a refresher, is to hedge three liability risks: interest-rate risk, credit risk, and yield-curve risk. As we discussed in a previous paper, we think the risks should be prioritized in that order given that interest rates have historically exhibited the highest volatility, followed by spread volatility and then yield-curve volatility.

In this paper, we do a deeper dive on each of these liability risks by answering four key questions that can help plans improve the design of their hedging portfolios:

1. Interest-rate risk: How should a plan decide between hedging its surplus and hedging its funded ratio? Our conclusion: Hedging the surplus generally makes sense for plans seeking balance sheet stability, while hedging the funded ratio may be better for those seeking to enhance benefit and contribution security.

2. Credit risk: What is the credit risk contribution from equities and how does it impact the credit-sizing decision? Our conclusion: Two methods can help answer these questions: 1) Calculate the duration times spread (DTS) for equities using an empirically observed spread duration and then determine how much credit to hold to achieve a 100% DTS hedge ratio against the liability, or 2) conduct an optimization exercise to find the credit exposure that minimizes funded-ratio volatility.

3. Credit risk: How should a plan decide on allocation sizing between intermediate and long-duration credit? Our conclusion: The optimal long versus intermediate split will be affected by a plan’s liability duration, return-seeking assets, and other variables. Understanding the sizing effect on funded-ratio volatility can help quantify the decision. 

4. Curve risk: How closely does a plan need to match the liability’s curve risk? Our conclusion: The curve match should be robust, but the costs and risks of seeking a “perfect” match may outweigh a nominal risk reduction benefit. 

We also address a “bonus” question we are often asked by plan sponsors: How should the success of a corporate DB plan be measured? Recognizing that performance against the liability is the ultimate measure of success, we offer thoughts on the distinct roles of LDI portfolio design versus portfolio management, discuss the role of an LDI benchmark and the importance of evolving it, and suggest an attribution framework.

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