Strategies for Hedging Interest Rate Risk in a Cash Balance Plan

Russell Investments // Strategies for hedging interest rate risk in a cash balance plan By: Justin Harvey, ASA, Asset Allocation Strategist JULY 2012 Strategies for hedging interest rate risk in a cash balance plan Issue: Over the past decade, the trend among public-sector and corporate pension plan sponsors from traditional “pay x service” defined benefit plans to cash balance (hybrid) plans has increased.1 What kinds of interest rate hedging investment strategies should sponsors of cash balance plans consider as they seek to manage funded status? Response: A wide range of different cash balance plan designs exists, so a hedging tool that will work well for one plan may not work as well for another. The plan design elements that most

impact the effectiveness of various hedging strategies are: 1. The interest crediting method; 2. The amount of legacy/retiree liabilities; and 3. The minimum interest crediting rate. Depending on the plan design, some of the investment strategies available for hedging interest rate risk are: 1. Selling credit default swaps to gain exposure to high-quality corporate bond spreads; 2. Selling Treasury futures to reduce interest rate exposure; 3. Purchasing duration-matching high-quality corporate bonds; or 4. Using swaptions with strategically chosen expiration dates and strike prices. 1 Even as recently as earlier this year, Bobby Jindal, governor of Louisiana, proposed converting his state’s pension plan to a cash balance formula. Source: Kozlowski , Rob; “Louisiana governor pitches pension changes.” P&I Online, January 26, 2012. A wide range of different cash balance plan designs exists, so a hedging tool that will work well for one plan may not work as well for another. Russell Investments // Strategies for hedging interest rate risk in a cash balance plan / p 2 While these strategies may help sponsors hedge interest rate risk, closely tracking liability movements with a plan’s assets is more difficult in a cash balance plan than in a traditional defined benefit plan. Background When plan sponsors first started implementing cash balance plans, there was some concern that the plans’ designs discriminated against older workers, because the shorter periods until retirement did not allow much time for interest earnings to compound.2 This didn’t stop the adoption of cash balance plans as cheaper alternatives to traditional plans. By 2004, 34 of the Fortune 100 companies were sponsoring open hybrid plans.3 While some of these plans have recently been closed or frozen, as of 2010, 34.1% of Pension Benefit Guaranty Corporation (PBGC) insured pension plans with 5,000 or more participants were hybrid designs, the most common of which is a cash balance plan.4 A cash balance plan is treated as a defined benefit plan for funding and regulatory purposes, but is similar to a defined contribution (DC) plan in that a participant’s benefit is an account balance. However, unlike in a DC plan, the plan sponsor still assumes the investment risk, because the value of the cash balance account is usually not tied to the return actually earned on the plan’s assets. The participant’s hypothetical account balance is credited with a “pay credit” each year (in an open plan) and an “interest credit,” which is essentially...

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