Hedging Interest Rate Risk Essential for DBs

November 27, 2012 (PLANSPONSOR.com) – A report underscores the necessity and analyzes the techniques available for defined benefit plans to hedge interest rate risk.

“For a pension plan to base asset allocation decisions primarily on total return without taking into account the impact of interest rates on funded status could leave the plan exposed to considerable volatility in funding ratio and surplus/deficit levels,” contend the authors of the J.P. Morgan Asset Management report, “Taming Duration: Tools for hedging liability interest rate risk.”  

The authors explain that while a typical duration exposure of a representative plan’s liabilities is 12 years, assets only provide about three years in offsetting duration, a duration mismatch of nine years. As a result, while a 1% fall in interest rates would increase the value of fixed-income assets in the portfolio, it would increase the size of liabilities still more, widening the gap in the funding ratio by 7%.   

The report lays out two interest rate hedging approaches for pension plans in a hypothetical case study: increasing the allocation of plan assets to long-duration fixed income and using derivative overlays. It also touches on a second order of risk that plans looking forward to an endgame investment strategy must confront—even a perfectly duration-matched portfolio comprised of the exact bonds used to construct the discount curve would not completely protect a pension plan from the adverse market movements associated with credit downgrades.   

The authors concluded there is no steady state in which pension plan asset returns exactly match projected liabilities; rather than a fixed and static match, the asset/liability boundary is a dynamic gap. “Thus, pension plans, regardless of funded status, have a single common requisite: the need for vigilant, proactive and informed oversight,” the report says.  

This report and more insights from J.P. Morgan can be found here.