One certainty about pension plans is that funded levels can be unpredictable. Minimizing interest rate risk has increasingly become a focus for plan sponsors looking to smooth out funded status movements to improve budgeting. In this article, we answer some key common questions related to the degree of customization needed to get the intended outcome from these assets.

Quick Refresher

Liability hedging strategies reduce rate risk by mimicking the liability movement (e.g., if liabilities grow 10% due to interest rates, liability hedging portfolio should grow by a similar magnitude, resulting in less movement in funded status). There are several ways to implement hedging in a pension. The simplest form of hedging is buying off-the-shelf bond funds, or a series of bond funds that match the total duration of the pension plan. On the other end of the spectrum is fully custom liability hedging, which involves having a separately managed account of individual bond instruments aligned with plan liabilities, producing desired exposures along the yield curve. Utilizing government bonds, credit bonds and derivatives when needed also allows for credit risk to be managed appropriately in consideration of the entire portfolio.

Bond Funds Can Effectively Hedge Liabilities


Fiction

Liability hedge implementation can largely impact funded status outcomes. Using bond fund(s) to match liability duration can provide reasonable funded status outcomes if yield curve shifts are parallel. However, bond funds are ineffective if the shape of the yield curve changes (e.g., flattens, steepens or twists). Figure 1 illustrates exposures for a plan that uses a blend of four bond funds to match liability duration. Between 62% and 222% of the liability is hedged at different areas of the curve, instead of the expected 100% that the plan sponsor targets in total. In this example, rising rates can have a negative impact on the plan funded status if a steepening yield curve causes longer duration assets to fall faster than the liabilities. With a custom liability hedging approach, plans can effectively achieve close to 100% hedging across the entire curve, producing more predictable outcomes.

Chart 1: Illustrative Hedging Analysis (100% Hedged)

Source: PNC

This example is for illustrative purposes only. The results in this example are based on the stated assumptions. Results have inherent limitations because they are not based on actual transactions, and hypothetical results may under or over compensate for the impact of certain economic and market factors, all of which can adversely affect results. Past performance is no guarantee of future results.

View accessible version of this chart.

Liability hedge implementation can largely impact funded status outcomes. Using bond fund(s) to match liability duration can provide reasonable funded status outcomes if yield curve shifts are parallel. However, bond funds are ineffective if the shape of the yield curve changes (e.g., flattens, steepens or twists). Figure 1 illustrates exposures for a plan that uses a blend of four bond funds to match liability duration. Between 62% and 222% of the liability is hedged at different areas of the curve, instead of the expected 100% that the plan sponsor targets in total. In this example, rising rates can have a negative impact on the plan funded status if a steepening yield curve causes longer duration assets to fall faster than the liabilities. With a custom liability hedging approach, plans can effectively achieve close to 100% hedging across the entire curve, producing more predictable outcomes.

This example is for illustrative purposes only. The results in this example are based on the stated assumptions. Results have inherent limitations because they are not based on actual transactions, and hypothetical results may under or over compensate for the impact of certain economic and market factors, all of which can adversely affect results. Past performance is no guarantee of future results

Custom Liability Hedging Is Accessible to Average Plans


Truth

There is a misconception that only the largest pension plans with $1 billion or more in pension assets have access to fully custom liability hedging solutions. Plan sponsors can access a custom-built portfolio of high-quality bonds with approximately $10 million in liability hedging assets. Furthermore, the cost to access experienced managers through an outsourced chief investment officer model tends to be less than the cost of purchasing off-the-shelf actively managed bond funds. So while cost and plan size may have been limitations decades ago, the industry has provided opportunities for many plans to implement more effective risk management strategies.

Plan Sponsor Should Customize Only at Higher Funded Status


Fiction

Customizing a 70% allocation to liability hedge will be more impactful to a plan’s funded status than a 30% allocation to hedging assets. For this reason, some in the industry have argued that plans should wait to customize when plans have more sizeable liability hedging allocations. Plan sponsors are better served taking risk in areas of the portfolio that are rewarded, specifically in the equity or return-seeking part of the portfolio. Purchasing a bond fund today with a goal to unwind later into a custom strategy could prove costly when funded level improvements and de-risking can happen very quickly. Further, starting now provides access to bonds that may be scarce or more costly if purchased in the future. Building a custom strategy that can provide immediate risk reduction and last through a wide range of environments is an effective way to minimize costs.

Custom Liability Hedge Helps With Plan Terminations


Truth

There are two primary ways that customization helps for a plan pursuing plan termination or annuity purchase in general. First and foremost, during the average 12- to 18-month timeframe that plans work through the termination process, a custom liability hedging solution can be the best way to minimize the variability in the termination cost. As assets move in line with the liabilities, the termination gap remains largely unchanged. We find that plan sponsors target shifting 100% of the assets into a liability hedging solution, and a customized portfolio most effectively minimizes surprises and allows for shifts as the termination liability is fine tuned. Second, for a larger well-designed custom liability hedging portfolio (roughly $100 million or more in liability hedge), insurance companies will take those assets in-kind and provide discounts to their annuity premium. This provides another benefit of cost reduction to plan sponsors as they look to offload their liabilities.

Conclusion

As the pension landscape has evolved over the years, plan sponsors have increased access to effective risk management strategies. Having a customized liability hedging strategy is no longer just for larger or better funded plans. Regular discussions with your investment advisor should help you get or remain on the right path toward preparing you for the future.

Ready to Help

For more information, contact Kimberlene Matthews, FSA, EA, CFA, Managing Director, Pension & Enterprise Solutions, at kimberlene.matthews@pnc.com.


Accessible Version of Charts

Chart 1: Illustrative Hedging Analysis (100% Hedged) 

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Profile 1 2 3 5 10 15 20 25 30
Fixed Income Duration (Years) 0 0.2 0.3 0.8 1.2 1.5 2.1 3.3 2.1
Liability Duration (Years) 0.1 0.1 0.3 1 2 2.2 2 1.5 2.6
Hedge Ratio 63% 142% 121% 82% 62% 70% 107% 222% 83%