Question

What are the two methods that can be used by a defined benefit pension plan to hedge interest rate risk and explain them?

Answer 1

Pension funds and life insurance companies with conventional asset and liability structures have high exposures mainly to two types of risks: equity risk and interest rate risk. Traditional asset portfolio risks are dominated by equity risks, which are considered to be the curse of declines of funding status. However, closer study reveals the funding status problem is more relevant to interest rate risks rather than equity risks. Liability values are highly sensitive to interest rates, and responsible for higher volatility levels of funding status. Some studies provide empirical evidences that interest rate risks are the key for funding status (see Ross 2007): two golden periods for pension funds are 1978-1981 and 1993-2000, during the first period funding status raised by an interest rate increase from 7.5% to 15%; the latter rise was triggered by increased excess returns on equities. However, during 1984-1992, when equity markets were also good, decreased interest rates cancelled out the benefit from excess equity returns and brought negative net effects to funding status. More recently, from 2000 to 2004, pension funds experienced their disastrous time because of continuously low interest rates. As a result of funding status’ plummeting, higher contributions are required from active pension or life insurance plan participants, defined benefits to beneficiaries may also be cut.

These situations are preventable by restructuring asset portfolios to hedge the interest rate risks which cause liability value changes. Typical pension funds and life insurances have liabilities with 10-17 years’ duration. Interest rate changes trigger liability values’ fluctuations; whereas, in normal assets portfolios, fixed income allocations usually range from 30 percent to 60 percent of the total asset values, with much shorter durations than liability durations. When interest rates go down, pension funds or life insurance will suffer from mismatched duration gaps and drastically experience funding status declines. We can shift, or at least partly shift the focus from asset-driven allocations to liability-driven investments (LDI).

There are two groups of LDI strategies, which can immunize portfolio from interest rate risks (see Moody, 2006, and Schweitzer, 2006), first is bond asset restructuring and second is the usage of alternative investments. The bond strategies structure bond assets to match the duration with liabilities. These strategies, however, have some disadvantages. First, pension funds and life insurance companies have existing asset allocations, shifting from current situations to liability-matched target may have tremendous structural adjustments and transaction cost; second, long term bonds, which are required in structuring new asset portfolios, may not have sufficiently liquid market; third, to fully match duration gaps between asset portfolios and liabilities, vast majority of assets needs to be reallocated to bond products, this asks for enormous switches from equities and sacrifice of the excess return from equity.

Interest rate derivatives are alternatives which can help immunizing portfolios. Compared to long term bonds, long-duration interest rate derivatives may have more liquid market, don’t require 100% funding, and don’t require large changes in existing asset portfolios. Some interest rate derivatives, for instance, Roller Coaster Swaps, are designed to have different underlying notional in order that for each tenor, the interest rate sensitivity is zero. The nature of these swaps can help structuring ideal LDI strategies. Notice that no strategy can fully hedge interest rate risk since liability structure changes over time, and there are always credit risks from counterparties.