Interest rate risk is often the most significant risk faced by defined benefit (DB) plan sponsors.

A simple metric for showing how much of this risk is being managed is the hedge ratio. The hedge ratio is the product of the plan's funded status, the percentage allocated to liability-driven investments (LDI), and the ratio of LDI duration and liability duration. Plan sponsors can improve their hedge ratio by pulling one or more of the following three levers:

  1. Contribute to the plan, thus increasing the plan's funded status and allocation to LDI
  2. Increase the allocation to LDI (either physically or synthetically)
  3. Increase the LDI duration

This paper illustrates the impact each of these levers can have on the hedge ratio and discusses how the third lever tends to have the most immediate impact on hedging interest rate risk.

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