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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
With recent improvements in funded ratios, many corporate defined benefit (DB) plan sponsors have been thinking about their derisking plans, including whether to increase their liability hedge ratios. At the same time, liquidity issues are top of mind, thanks to the 2022 UK pension crisis, elevated benefit payments as liabilities mature, and capital calls from plans’ private investments. So, the timing seems right for a fresh look at setting and managing liability hedge ratio targets, including liquidity considerations and the implementation tool kit.
In this paper, we offer:
The primary goal of increasing the liability hedge ratio is to help reduce projected funded-ratio volatility, a benefit that is generally well understood. But setting a higher hedge ratio may also help narrow the range of volatility outcomes, which can vary depending on equity/bond correlations. In other words, raising the hedge ratio could make funded-ratio volatility a bit more forecastable.
So why not fully hedge the liability, especially given that interest-rate risk is unrewarded? For many plans, particularly those that hold meaningful capital in return-seeking assets or that have a longer liability duration, doing so would entail significant reliance on interest-rate derivatives, which are not costless and introduce liquidity risk that must be carefully managed. That said, we think interest-rate derivatives can be very useful …
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