From Volatility to Stability: A Macro Hedging Approach for U.S. Pension Systems

By: Ortec Finance

This report from Ortec Finance examines how macroeconomic developments, particularly declining interest rates, can translate into balance-sheet risks for U.S. pension funds. Using a stylized case study, they show that incorporating strategies like interest rate hedging can meaningfully reduce downside risk and enhance funding stability in an uncertain macroeconomic environment.

Over the course of 2025, global markets swung between optimism and caution as institutional investors balanced easing inflation trends and large equity gains against policy uncertainty, structural valuation concerns, and mixed macroeconomic indicators. These factors contributed to some of the most volatile market episodes since the 2008 financial crisis, as confidence and risk aversion alternated throughout the year.

Many pension funds, and particularly those in the United States, reported stable or improved funding ratios in 2025, mostly due to the strong equity market conditions. Asset values rose significantly, while a relatively stable long-term interest rate environment limited increases in the present value of liabilities. These events appeared to be reassuring and suggested a return to healthier balance sheets after years of strain, but they also masked vulnerabilities.

Driven largely by interest rate cuts by the Federal Reserve coupled with broader macroeconomic and political uncertainty in the United States, the U.S. dollar fell by roughly 10% against other major currencies, marking 2025 the largest annual decline since 2017. As confidence weakened, investors looked for new safe havens. The shift to explore new markets led to the appreciation of minerals, such as gold and silver, as well as the growth of capital flows into foreign assets in Europe and Asia which further strengthened other currencies relative to the dollar.

However, the depreciation of the U.S. dollar is not entirely unexpected. Lower interest rates, existing trade tariffs, and currency weakness have contributed to higher import prices and renewed inflationary pressures for U.S. households, companies, and institutional investors. At the same time, a weaker dollar lowers the foreign-currency price of goods produced in the United States, which can improve export competitiveness over time, support domestic production, and strengthen external demand.

This report examines how macroeconomic developments, particularly declining interest rates, can translate into balance-sheet risks for U.S. pension funds. Using a stylized case study, we show that incorporating strategies like interest rate hedging can meaningfully reduce downside risk and enhance funding stability in an uncertain macroeconomic environment.

Public pension plans often discount liabilities using a fixed expected return on assets – an approach that originates from an accounting convention rather than strict market valuation. Under this framework, changes in long-term interest rates do not mechanically affect reported liabilities and funding ratios look stable even as market conditions evolve. Consequently, implementing interest rate hedging often seems counterintuitive for public funds. Because their liabilities are “fixed” in accounting terms, hedging market rates would introduce, rather than reduce, volatility to their funding status.

Does this mean that public pension funds are immune to interest rate risk? Not exactly.

In the short run, a drop in interest rates may actually make a public pension fund’s funding ratio appear healthier because the value of its fixed income assets rises while its reported liabilities remain flat. Unfortunately, this strategy hides a deeper long-term issue. As rates fall, the forward-looking expected returns on safe assets decline. To maintain their high fixed return targets (often 7% or higher) in a low-rate world, public pension funds are forced to drift into riskier, less liquid asset classes to close the gap.

As the accounting value of liabilities of public pension funds remains unchanged, the economic value of the promised cash flows does move with interest rates, irrespective of how they are reported on the balance sheet. Fixed discount rates stabilize accounting outcomes, however they do not protect pension promises from changes in the value of money. For plans with liabilities that have significantly longer duration than their assets, falling rates increase the true economic value of the obligation far more than the assets.

To reduce funding ratio sensitivity to falling interest rates, it is possible to hedge using interest-rate swaps. In a swap operation, the fund receives a fixed interest rate and pays a floating rate. When market interest rates fall, the value of this position increases, which offsets the rise in the economic value of pension liabilities. Conversely, if the interest rates rise, the hedge loses value, but the liabilities become less expensive in economic terms.

Our case study sheds light on a key insight. Interest rate hedging is not intended to enhance returns in all scenarios – instead, it is to protect funding ratios in adverse scenarios. Regardless of how much return a given portfolio is seeking, the benefit of having both hedging strategies can help reduce unnecessary sources of volatility. While both strategies perform similarly, the inclusion of interest rate swaps leads to more stable funding ratios in scenarios where long-term interest rates decline. Over time, this added stability can lower the risk of funding shortfalls and reduce the likelihood of corrective contributions by plan sponsors or taxpayers.

Click here to read the complete report on the Ortec Finance website.

About Ortec Finance: We model and map relevant uncertainties to help you monitor your goals and decisions. Established by foremost experts in the fields of Econometrics and Technology in 1982, we have garnered an exceptional reputation for reliability. Serving over 600 clients across more than 20 countries, we play a pivotal role in enhancing our clients’ investment decision making and managing their uncertainty. Headquartered in Rotterdam, The Netherlands, we also have offices in Amsterdam, London, Toronto, Zürich, Melbourne, Singapore and New York.