Article October 10, 2019

Pension investing – hedging interest rate risk with a collar

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Interest rates can move pension funded status up or down significantly. An interest rate collar can protect funded status against a decline in rates, while rate increases can still improve funded status.

We’ve seen significant interest rate volatility in 2019.  Recent moves in long term interest rates have been multiples of historic standard deviations which calls into question the relevance of past experience when assessing risk today.  The 10 year US Treasury yield dropped approximately 50 basis points (0.50%) in one month (from July 15 to August 15), 120 basis points (1.20%) in 8 months thru August 31, and rose 30 basis points (0.30%) in only a few days during September.  If pension liabilities are not hedged, these changes will cause large funded status changes which can have a significant financial impact.  A typical US corporate pension plan with liability duration of 14 years would have experienced an 18% increase in liability value YTD thru August 31st.  Conversely, liabilities would have fallen 4% over several days in September just due to the changes in interest rates.

It can be a difficult risk/reward tradeoff decision to transfer return seeking assets to liability hedging assets. That said, liability hedge ratios can be increased significantly by using derivative instruments without having to make that difficult decision.  This means that allocations to return-seeking assets, and consequently expected returns, can be maintained while still increasing interest rate hedge ratios.  Some large plan sponsors are already using these techniques.  One approach that may be particularly appealing is using interest rate collars.

For example, an interest rate collar can be implemented by collecting premiums for selling off the upside associated with interest rate increases above 50 basis points (0.50%) over a 2 year period.  This premium would pay for funded status protection if rates decline more than 50 basis points over a 2 year period*. These collars can be structured in a way to reduce the total premium to $0 (i.e., the value of the premium sold on the upside would equal the premium purchased to protect the downside). The interest rate options market generally prices the risk that rates increase by a given amount (e.g., 50 or 100 basis points) vs. fall reasonably symmetrically.

The size of the collar can be chosen to target a funded status floor, allowing for existing interest rate sensitive assets, without shifting return-seeking assets to fixed income.  Note that credit spreads and other factors will still cause some interest rate volatility, and the plan funding level will continue to be sensitive to the movement of return seeking assets such as equities.

Another example for those that want to capture more funding improvement (should interest rates rise), but still protect against some downside movement, would be to allow for the first 100 basis point (1%) increase in rates to improve funded status and take in premiums to forgo further improvements, assuming interest rates increase more than 100 basis points.  For many plans, a 100 basis point increase is more than enough to put the funded status at or well above 100% (perhaps to the point of unusable surplus).  Plan sponsors can determine at what point to sell off upside.  These premiums can be used to purchase protection against rate declines of more than 100 basis points (zero premium collar) or plans could choose to pay a net premium in order to protect against less material declines.  For example, for a net spend of 30 basis points (0.3%) per year, plans can protect against interest rate falls of more than 50 basis points, while forgoing funding improvements beyond a 100 basis point rise.*

Hedging against interest rate movements does not need to be an all or nothing decision.  Nor does it mean that return-seeking assets need to be shifted to long bonds, thereby reducing expected future investment returns.  Collars can be used, in combination with a reduction in traditional interest rate hedging, to retain some benefit if interest rates rise, while maintaining some protection if rates go the other way.  Traditional interest rate hedging methods may not be the most efficient way for a plan to position for future interest rate moves and manage risk, given each plan’s unique situation. Custom rate collars can be designed to take account of current hedge ratios, current funded status, potential unusable surplus levels and current sponsor views on levels of interest rates (“…they can’t go down any more, right?”).

*Pricing as at September 15, 2019.  Examples apply over a 2 year time horizon, using options on interest rate swaps with a term of 15 years (“2Y/15Y” swaptions).  Premiums paid assume a starting total plan interest rate hedge ratio of 60%, which increases to 100% in the event that interest rates move beyond the levels described 2 years after inception.

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