De-risking gets a lot of attention. However, most defined benefit plan sponsors are really seeking to make better risk/reward trade-offs and improve the chances of meeting their plan obligations. This risk budgeting exercise can be impacted by many plan-specific factors, so the investment framework should recognize that all plans are different. What is most important is finding the strategies and solutions that best fit your unique risk budget and tailor your investment strategy appropriately – a process called right-risking.

Michael Augustine, Managing Director, Portfolio Management, TD Asset Management Inc. (TDAM), Liam Hartigan, Vice President, Portfolio Management, TDAM, and Pawel Piesowicz, Vice President, Portfolio Management, TDAM, have written an insightful, in-depth article about right-risking, which explains how pension plans can set their hedging objectives.

Types of Hedging Ratios

Hedging means allocating a plan's assets to have similar market risk exposures as its underlying liabilities. The expectation is that these assets will experience a sensitivity to market movements in line with a portion of the plan liabilities. This helps to reduce the funded status volatility.

There are four types of hedging ratios a plan can adopt in order to right-risk. These ratios are tied to the four primary factors which impact liability volatility and may contribute to funding ratio volatility: interest rate changes, the shape of the yield curve, credit spreads and inflation.

The Interest Hedging Ratio measures the degree to which a plan's funded status is protected against a parallel shift in the nominal yield curve.

The Yield Curve Hedging Ratio measures the degree to which a plan's funded status is protected against a non-parallel shift in the nominal yield curve.

The Credit Hedging Ratio measures the degree to which the plan's funded status is protected against changes in credit spreads.

The Inflation Hedging Ratio measures the degree to which the plan's funded status is protected against changes in inflation expectations.

Setting the Primary Hedging Objective

Most plans may have multiple hedging objectives because there are multiple valuations of a plan's liability. To set the primary hedging objective, a sponsor needs to determine whether the plan's goal is to lock in its Funding Ratio or its Funding Position in dollars.

If a plan aims to lock in its Funding Ratio (i.e. ratio of assets to liabilities), it should use a target Interest Hedge Ratio equal to its Funding Ratio. Most plan sponsors are focused on this metric, which is meaningful for plans seeking protection against breaching key levels, such as the 85% solvency level, which could trigger additional funding requirements.

Some plans, however, are focused on their Funding Position in dollars. This could be the case for a plan nearing wind-up and seeking certainty around its dollar surplus or deficit in order to minimize the risk of a surprise in the contributions required to fully settle benefits. A plan seeking to lock in its Funding Position or dollar surplus/deficit should use a target Interest Hedge Ratio equal to 100% of its liabilities.

Setting the Target Hedging Level

The target hedging ratio is determined by a plan's specific objectives. These can vary based on many factors, including the Plan Status (whether the plan is open or closed to new members, which has implications for its investment time horizon, with closed plans having shorter horizons) and Current Funding Position (well funded, slightly overfunded or underfunded).

Using a full set of opportunities

Given the multiple objectives they often face, plan sponsors should use a full set of investment opportunities which includes public, private and overlay market instruments.

Bond overlay strategies can be a great right-risking tool. The application of complementary equity management styles and the inclusion of alternative assets could help boost returns while reducing a portfolio's total risk profile. This is due to the lower correlation between complementary equity management styles and alternative assets.

Testing the hedging strategy

It's crucial to test the proposed hedging strategy. This will help plan sponsors understand not only long-term expected outcomes, but also potential short-term downside tail risks

Target hedge ratio testing and selecting the appropriate amount of risk to hedge should be based on holistic, internally consistent and realistic scenario analysis. With such a clear sightline to the key drivers of risk, plan sponsors can enjoy a greater sense of confidence that any proposed hedging strategy will meet their expectations.

The result will be a better control of the plan.