An interest rate hedging diagnostic

diagnostic
diagnostic

One of the biggest strategic decisions faced by defined benefit pension plans is that of choosing an interest rate hedge ratio. This is never a totally straightforward decision, since it involves a tradeoff between competing objectives. The decision is, however, much trickier for some plans than it is for others.


In the latest issue of Russell Investments Communiqué, Bob Collie and I introduce a broad diagnostic that helps to identify the key pressure points. While a hedging decision should be based on comprehensive asset–liability analysis, not just the high–level framework built into this tool, the diagnostic sets the stage by highlighting what are likely to be the most important considerations given a particular plan’s situation.

Four key considerations

The interest rate hedge ratio is a measure of how much interest rate exposure should be built into the asset portfolio to offset the interest rate exposure in the liabilities.

Our diagnostic is based on four key areas of consideration: risk tolerance; funding and accruals; current commitment to liability–driven investing (LDI); and expectations regarding future interest rate movements. These topics are regularly raised in conversations with our clients and are important discussion points for any investment committee to consider.

For plans which are approximately “typical” on all four considerations, there is no obvious need for an immediate change in strategy. Clearly, there may be other factors that may lead to a different conclusion, but, for these plans, the diagnostic does not identify any clear pressure points.

But what if a plan is not typical in one or more regards?

For plans that fall to the left on one or more of the considerations above, an increase in the interest rate hedge ratio may be appropriate. These are plans that are less able than others to take interest rate risk, have less need to do so, have a larger mismatch between assets and liabilities and/or do not anticipate earning a positive return from taking interest rate risk. That points to a need to close the gap between the interest rate exposure in the assets and the liabilities.

Similarly, plans which fall on the right might consider reducing their hedge ratios. However, the application of the diagnostic is not symmetrical, and it takes more to justify a reduction in hedge ratio than to justify an increase. That’s because a moderate or low interest rate hedge ratio already represents a large position, a significant bet that interest rates will rise faster than implied by the forward curve. A high hedge ratio, in contrast, is merely the absence of a bet that interest rates will rise and not (unless the hedge ratio is above 100%) a bet that they will fall.

More complex situations

The situation is more complicated when a plan falls to the left side of the chart on one or more considerations, and to the right on others.

Consider, for example, the situation where there is a strong view that interest rates will rise, but the plan is on the left with regard to, for example, strength of funding. In this case, increasing the bet on interest rates most likely does not make sense, since the upside from being right is constrained by the possibility of trapped capital. If, on the other hand, there is a strong view that interest rates are likely to fall, then it most likely does make sense to consider increasing the interest rate hedge ratio, even if, for example, the plan is significantly underfunded. This is an example of the asymmetry mentioned above.

And other combinations of characteristics may make the decision even more involved. Some combinations allow considerable flexibility in selecting a preferred approach. Others are more problematic. For example, in the case of a poorly funded plan whose sponsor is very sensitive to risk in the pension plan, a point may be reached where it becomes unrealistic to rely on investment strategy alone to achieve the desired result.

In summary, even though the above diagnostic is just a high-level tool, it offers useful pointers as to the key considerations that are likely to drive a plan’s choice of interest rate hedge ratio.


AI-25963-12-20

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