- LDI Team Chair and Multi-Asset Strategist
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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:
- A framework for setting the liability hedge ratio — We think the focus should be on balancing the benefits against the liquidity risks and implementation costs.
- Portfolio construction insights — We believe physical long-duration assets should generally be prioritized over synthetic exposure, but we also see a role for synthetics to supplement the hedge ratio, provided the plan is positioned to manage liquidity risk. We also think there’s a role for liquid, liability-aware diversifiers in the return-seeking portfolio.
- Best practices in completion mandates — We consider the range of duration-hedging instruments and discuss trade-offs between physical and synthetic exposure, including cost and liquidity.
Increasing the hedge ratio: A case study
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 …
To read more, please click the download link below.
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