2023: The Year of the Pension Hedging Revolution

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• On: 08/31/2023 11:52:13
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This is an excerpt from NCPERS Summer 2023 issue of PERSist, originally published July 18, 2023.

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.

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. 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.

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).

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. In 2023, 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 may be possible to have a symmetrical collar, providing protection below a specified percentage and allowing gains up to that same specified percentage for the next 12 months, while potentially collecting a small premium. Employing this strategy can narrow potential equity return outcomes for pension plans even as uncertain economic conditions loom.
 
About the Author:

Shauna Hewitt is a Senior Investment Director at LGIM America. In her role, she focuses on Consultant Relations and Institutional Sales efforts in the Midwest Region. She covers Corporate Defined Benefit and Defined Contribution clients, Public Plans, Taft-Hartley as well as Endowments and Foundations.

She has over 25 years of investment industry experience. Prior to joining LGIM America in 2018, she served as Managing Director at Pavilion Global Markets. Shauna founded Lambright Financial Solutions which was later acquired by Knight Capital Americas. She has also held senior roles at Loop, BNY Brokerage and CRA RogersCasey. Shauna began her career with Donaldson, Lufkin & Jenrette.

Shauna serves on various committees of community outreach services in Chicago in addition to being a former board member of Women Investment Professionals (WIP), current WIP Professional Development committee member and member of National Association of Securities Professionals. She is also the past chair of LGIM America's Women's Collective.

Disclosures

This material is intended to provide only general educational information and market commentary. This material is intended for Institutional Customers. Views and opinions may change based on market and other conditions. The material contained here is confidential and intended for the person to whom it has been delivered and may not be reproduced or distributed. The material is for informational purposes only and is not intended as a solicitation to buy or sell any securities or other financial instrument or to provide any investment advice or service. Legal & General Investment Management America, Inc. does not guarantee the timeliness, sequence, accuracy or completeness of information included. Past performance is no guarantee of future results. The strategies discussed above utilize investments in derivatives, which include inherently higher risks than other investments/strategies and may not be successful in all market conditions. Derivatives are for sophisticated investors who are able to bear the risk of loss of capital. Please see our full article for additional disclosures.