Three levers that dial a hedge ratio up or down

Many pension plans that follow liability–driven investing (LDI) strategies pay close attention to their hedge ratios. A new paper explains the role of three different levers in managing them.

Funded status, LDI allocation and duration ratio

A hedge ratio is a quick and simple measure of the extent to which a defined benefit pension plan has committed to LDI. Specifically, it measures the sensitivity of the plan’s assets to a change in interest rates as a proportion of the sensitivity of the plan’s liabilities to the same change.

In a new paper, my colleagues Justin Owens and Brandon Wilson show how the hedge ratio can be decomposed into three parts. Each of these is tied to a specific action (or lever) that can be used to manage the asset–liability interaction.

The decomposition is as follows:

Hedge ratio formula

The first lever is funded status: the larger the assets, the bigger the gains and losses that result when interest rates move. The action that moves this lever is contributions from the plan sponsor. However, contribution policy is really about managing plan sponsor cash flows and funded status (and, increasingly, PBGC premium costs)—and only marginally about managing the hedge ratio. So the other two levers are, in practice, more important.

The second lever—the proportion of the assets allocated to LDI—has long been the main focus in asset–liability management. This is generally seen as a trade–off between risk and return: increasing the allocation to LDI assets typically comes at the expense of the allocation to some other asset class that’s expected to deliver higher returns.

And that’s why the third lever—which is often overlooked—can be so useful. As Justin and Brandon explain: “While a common strategy for LDI managers is to match the LDI duration … extending fixed-income duration beyond that of the liability duration can be a more efficient way to improve the plan’s hedge ratio.” And this can be done within the existing LDI portfolio; there’s no need to take money out of the return–oriented asset allocation. One example of a duration-extension strategy that we have covered in a previous post is the Hedge Long First strategy.

At some point, more precision

The hedge ratio is based on the sensitivity of the assets and liabilities to changes in the overall level of interest rates. Those changes are the primary source of variation in pension plan funding, but the hedge ratio can sometimes be an imperfect guide, especially when the LDI focus grows stronger and other factors become more significant. This means that the role of the duration lever tends to be greatest in the early and middle stages of an LDI program, and tends to diminish as the hedge ratio moves above 70%–80% and the program becomes more finely tuned.