What is the optimal hedge ratio?, and other existential questions. Questions revolving around interest rate hedge ratios have consistently been one of the most popular topics of client conversations for the past several years. How a hedge ratio should change over time, the potential use of derivatives to complement physical securities as part of a hedging program, or what other plans are doing with their hedge ratios have all come up multiple times in one way, shape or form.
Ultimately, many of these questions get at what clients are really trying to figure out – what is the optimal hedge ratio? We noted earlier that many plans have been increasing their hedge ratios in recent years. As with many things in life, there is no “one size fits all answer” and attempting to identify an “optimal” may not be realistic.
Nonetheless, we would argue that various factors may cause a plan to lean more in one direction than the other with respect to its hedge ratio, such as the funded status of the plan and how material it may be with respect to the sponsor. Identifying and assessing those factors can be used to help fine tune and, to a certain point, quantify what that hedge ratio may be for a particular plan. We expect more sponsors to attack this question in 2020, in particular as their allocation to LDI-type instruments continues to increase.
Lower rates may dampen 2020 risk transfer activity. While many sponsors still aspire to get out of the pension business, the lower interest rate environment may temporarily impede some of those plans. Indeed, lower rates and the pain they inflict on DB plans may provide additional impetus for sponsors to put a plan in place to ultimately shrink or terminate their plans. Nonetheless, in the short term lower rates raise the value of liabilities and dampen funded levels, potentially preventing the effectuation of a risk transfer transaction.
Earlier, we noted that risk transfer activity remained healthy in 2019 despite the low interest rate environment. However, these transactions often take anywhere from six to twelve months to complete, meaning a number of the transactions that closed in 2019 was actually considered and evaluated in 2018 when interest rates were higher.
Playing that forward, the low interest rate environment of 2019 may have a depressing impact on activity levels for 2020. As seen in Exhibit 5, the range of yields on 10-Year US Treasury bonds was notably lower in 2019 as compared to 2018. Some sponsors that may have been contemplating a pension risk transfer transaction in recent months, which would subsequently close in 2020, may have held off given the fall in interest rates during the course of 2019.
