Pension plan LDI
Avoiding pitfalls from long bonds, protecting against low rates, and benefitting from rate increases
Pension sponsors have struggled for decades with the difficult tradeoffs that come from hedging potential increases in pension liability values due to declining interest rates. Owning long duration bonds is by far the most common tool that has been used to hedge against rate declines, but usually comes at the sacrifice of holding equities or benefitting when rates rise. To the extent sponsors have been holding long bonds, they’ve generally done a very good job of protecting funded status when rates fall (which has been fairly common). If rates increase though, the benefit to a pension plan may be muted due to these investments. In a period of historically low interest rates where many are optimistic about rate increases, swaptions present an opportunity to protect against interest rate declines while still being able to benefit from interest rate increases.
Interest rates have declined significantly over the past 30 years (see chart below of the 10-year treasury yields since 1990):
US ten year Treasury yield
The risk of declining interest rates is the largest funded status risk for most pension plan sponsors, so why is it such a difficult decision to hedge against rate declines? Most pension plans are well below 100% hedged from such declines. Because they aren’t 100% hedged, we have seen sponsors grapple with significant funded status reductions over the years. First, while holding long duration bonds works well for protecting funded status against rate declines, they also reduce funded status improvements should interest rates rise.
When rates rise, plan sponsors happily see the value of pension liabilities decline and prefer to not see an accompanying decrease in asset values due to holding long bonds. The psychology of not wanting to miss out on funding level gains from higher interest rates has driven many plan sponsors to forgo larger allocations to long duration bonds and for others to use derivatives such as interest rate swaps or Treasury futures.
In addition, hedging rates with long bonds typically means shifting from growth assets into long bonds (unless derivatives are used). Such a shift reduces a plan sponsor’s long-term expected return on assets by a significant amount, potentially 3%-4% per year on every $1 shifted, depending on equity risk premium assumptions. Thus, it is not a surprise that most plan sponsors have not fully hedged against rate declines by holding sufficient long duration bonds to do so.
For pension plan sponsors that don’t want to miss out on the upside potential by hedging against the downside of declining rates, there is another option: the swaption. A swaption is an option to enter into an interest rate swap on a given date in the future (e.g. 1 year) at a given rate (e.g. 1.5%). A swaption can increase in value when interest rates fall, providing the buyer with a hedge against this outcome. If interest rates rise, the swaption value will fall. However, the value of the swaption at purchase can be small relative to the potential payoff if rates fall, so the risk/reward is asymmetric. Buying a swaption can thus be thought of much like paying an insurance premium: pay a relatively small, known amount today to protect against what could be a large loss in the future.
Using a swaption to hedge interest rate risk means that a plan sponsor can maintain a high allocation to growth assets, benefit from rising interest rates, and protect against falling interest rates. Many sponsors would also be happy to trade off some of the benefit that they may see from rising interest rates in exchange for a lower, or zero, up-front premium to protect against falling rates. This involves buying and simultaneously selling swaptions at different interest rate levels – this is known as a swaption collar. For example, assume long treasury rates are currently 1.0%. A plan sponsor may get full protection from long treasury rates falling below 0.5%, but would forgo any benefit from rates rising beyond 2.5% for the term of the swaption. For frozen pension plans especially, there is a point where a plan does not need additional funded status increases as many plans would end up in a surplus position with any modest rate increase. Selling swaptions for rate increases above this threshold, or as part of an interest rate driven glide path, would provide sponsors with premiums that could be used to buy protection against falling rates or for other purposes. Note that interest rate spread risk (the risk to a sponsor that corporate yields drop more than treasury yields) is well hedged by growth assets (equities).
Many sponsors might look at current interest rates, which are historically low, and believe that they can’t really go lower – the mantra that rates can’t go lower has been around for well over a decade. First, rates could still go lower and can even go negative, as we’ve seen in many countries, so interest rate protection should still appeal to pension plan sponsors. Second, there are economic scenarios where rates could increase, and these scenarios can be reflected in asset allocation and investment strategy decisions.
The table below outlines a brief summary analysis for a typical pension plan ($90m assets/$100m liability value /liability duration=14 years / asset duration = 3 years):
A sports analogy may be appropriate here to compare hedging pension liabilities against interest rate declines (100% funded plan for ease of comparison) with common long bond strategies versus swaptions. In the chart below, Defense measures alignment of a strategy vs rate declines and Offense measures alignment of ability to outperform liabilities:
As plan sponsors evaluate their future game plan, swaptions can provide an attractive way to hedge against declining interest rates while allowing for any rate increases to help improve funded status. Swaptions also do not need to take assets away from long term growth investments to provide a hedge against rate declines. Swaptions can be a valuable tool to help plan sponsors both protect and improve funded status.
River and Mercantile has significant experience in analyzing swaptions and can help with education, structuring, and pricing alongside current consultants.