2023: The Year of the Pension Hedging Revolution
Despite a decline in most public asset classes, 2022 ended with improved funding positions for most corporate pension plans. Interest rates hit their highest points in over a decade, which caused the liabilities to decline more than the assets—especially for more under hedged plans.
Figure 1: Funded status has improved for many plans
Source: LGIM America. For illustrative purposes only. In these scenarios, we assume the return seeking asset (RSA) bucket is composed of a simple S&P 500 allocation, and the liability hedging asset (LHA) allocation is Bloomberg US Long Credit Index. We used a stock set of liability cash flows to approximate a 12-year duration and a present value of $1 billion. We used the Ice BofA A-AAA Corporate Bond Discount Curve to value the representative cash flows. Additionally, on the asset side, we assume quarterly rebalancing back to target weights for the illustrative scenarios.
With ever-present uncertainty around interest rates, inflation, recession, geopolitics and more, we believe 2023 will see many plan sponsors move to preserve their funded status gains and narrow the range of future outcomes through hedging strategies. In this blog post, we highlight three hedging opportunities to evaluate for 2023.
Capitalizing on the inverted yield curve opportunity
Many pension plans have used long-dated STRIPS as a “blunt tool” to add interest rate duration to hedge the liabilities. We say it is blunt because STRIPS do not hedge as well when the yield curve steepens. Fortunately, for those who held STRIPS, the yield curve flattened substantially, and even inverted in 2022 — meaning the strategy has done quite well. And historically speaking, the yield curve tends to steepen dramatically after a Fed rate hiking cycle, as shown below. In other words, now may be an opportune time for plan sponsors holding STRIPS to move to an LDI completion framework and hedge against a potential steepening yield curve scenario.
Figure 2: Historically, yield curve steepens at end of rate hiking cycle
Source: Bloomberg. Data as of December 31, 2022.
Monetizing your glidepath
Implementing glidepath frameworks have been popular investment strategies for over a decade, and we have seen many plans de-risk over the past year due to hitting specified funded ratios and/or interest rate levels. For plans that have not yet reached the end state of their glidepath, we may recommend looking into monetizing the future glidepath triggers by selling payer swaptions.
In this case, the plan would sell payer swaptions, which are options on interest rates, which the buyer could exercise if interest rates rise to a specified level. If rates fall, or stay below the strike price through expiry, the plan keeps the premium paid by the buyer at inception. If rates rise above the strike at expiry, the option will be exercised and the plan enters into a receive fixed/pay floating swap — an action that effectively buys duration, increasing the interest rate hedge, which is in line with the plan’s glidepath. This strategy is designed to allow the plan to receive an upfront premium while committing to a decision that was already established via their glidepath. Of course, it’s not guaranteed that the plan’s funded status will be better when rates rise, as credit spreads and return-seeking asset performance may offset the gains due to rising rates. It is critical that the plan sponsor explore the strategy in greater detail prior to implementing.
While we believe this strategy makes sense for those on a glidepath in most market environments, periods with higher interest rate volatility may result in a higher premium for selling swaptions (and consequently may also mean there is a higher chance of the swaption being exercised).
Figure 3: Capitalize on higher volatility environment
Source: Bloomberg and LGIM America. Data as of December 31, 2022. The underlying reference rate for swaptions are swap rates, whereas pension liabilities reference Treasury yields, which introduces basis risk. In other words, swaptions introduce additional tracking error into the liability hedging program. It is important to understand the current market environment and the potential risks prior to adopting this type of strategy. This strategy's use of derivatives is designed for sophisticated investors who are able to bear the risk of capital loss.
Reducing equity risk
One of the main themes of 2023 is the debate over the timing and severity of the upcoming recession that most market participants seem to be forecasting. Historically, one popular way to protect against equity downside without paying an upfront premium has been to implement a put-spread collar. This allows the plan sponsor to protect against downside equity returns up to a point, while capping the upside. Today, plans may want to consider a standard collar structure, one that provides unbounded downside protection. In the past, market pricing of standard collars limited upside substantially, but due to increases in interest rates and flattening implied volatility skew, this is not currently the case. Today, it is possible to have a symmetrical collar, providing protection below 90% and allowing gains up to 10% for the next 12 months, while still collecting a small premium. Employing this strategy can narrow potential equity return outcomes for pension plans even as uncertain economic conditions loom.
Figure 4: Illustrative pay-off diagram at expiration
Source: Bloomberg. Data as of January 4, 2023.
With pension plan sponsors grappling with so many macroeconomic concerns—inflation, Russia, recession, central bank policy, declining profitability and stretched valuations—2023 is set to be a year of heightened uncertainty. To preserve the hard-earned funded status gains of 2022, plan sponsors should explore the various hedging structures, including capitalizing on short-term tactical opportunities and establishing long-term strategies to shape the plan’s funded status outcomes.
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