Our Insights

May 2014

Constructing a Liability Hedging Portfolio: A Guide to Best Practices for US Pension Plans

Amir Farahani, Ming Yan

    • To construct an effective liability hedging portfolio, a key first step is to evaluate the variety of ways liabilities can be calculated and discounted and to identify the most relevant liability metric for a plan sponsor’s circumstances. Plan sponsors should also define the acceptable level of surplus risk and carefully consider the appropriate duration of the liability hedging assets—shorter duration assets often have a meaningful mismatch to most defined benefit pension liabilities.
      Plan sponsors should not construct a liability hedge in isolation, as the size and composition of both the growth portfolio and liability hedge will have important implications for each other. Since the end goal is to maximize portfolio return at a controlled level of risk, the liability hedging portfolio should not attempt to perfectly immunize a cash flow stream—an extremely difficult task when considering real world constraints of corporate bond issuance, transaction costs, and liquidity—but rather optimize duration, curve, and credit spread exposures within the broader context of the total plan’s risks related to both its assets and liability.
    • We recommend plan sponsors consider the use of more complex fixed income structures to manage their liability hedge programs. Most notably, we believe prudent use of derivatives (and, implicitly, some degree of portfolio leverage) should be considered, as bond futures, interest rate swaps, swaptions, and other techniques provide far more flexibility to optimize the portfolio when compared to a plain vanilla physical bond portfolio. Derivatives may also allow for a more capital-efficient liability hedging allocation, which we believe is paramount when looking at the low level of return provided by fixed income in the current environment. Still, even with these derivatives-based strategies, a “perfect hedge” is not attainable.
    • Plan sponsors should think carefully about the active management implications of constructing the liability hedge, particularly for those plans that target low surplus volatility and maintain heavy allocations to fixed income. In normal environments, a plan with the majority of its liability hedging assets devoted to bond managers (typically with moderate tracking error) will not be able to generate the same level of value add as a plan with a more diversified portfolio invested in higher active risk strategies such as equities, hedge funds, and private investments.
    • Best practices when developing a liability hedging framework include:

– Understanding and defining the liability,

– Quantifying acceptable surplus risk,

– Acknowledging the basis risks in replicating the liability hedging benchmark,

– Monitoring the interaction of credit and equities,

– Emphasizing capital efficiency given the lower returns of liability hedging assets, and

– Considering derivatives as part of the toolkit.