Setting the Interest Rate Hedge for Pensions
In setting the investment strategy for a defined benefit (DB) pension plan, a decision regarding percent of liabilities to hedge must be made. There is no one right answer – different plans have different views dependent on varying circumstances. In this whitepaper, we present the strategic perspective of our philosophy when setting the hedge level of a DB pension plan.
LGIM America recommends that plans set a strategic hedge ratio equal to the plan’s funding ratio (i.e., 80% hedge for an 80% funded plan). This minimizes short-term risk, which is often uncompensated due to the uncertain future level of interest rates. Rather than focus on a plan’s historic hedge levels or current interest rate levels, we recommend that a plan primarily evaluate its investment strategy relative to this strategic hedge ratio target.
Plans may diverge from this strategic hedge ratio to reduce longer-term risks, as various trade-offs and cost considerations are plan specific. We will explain the rationale behind setting the strategic hedge ratio to minimize short-term risk, as well as discuss the longer-term risks many pension plans face.
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