Optimizing hedge portfolios for well-funded pensions

As more and more plan sponsors consider the possibility that defined benefit pensions may have an ongoing role to play in their retirement benefit packages, they need to be able to envision an allocation model capable of sustaining these plans in a risk-controlled way.

Well-funded pension plans that invest most of their assets in traditional liability-driven investment (LDI) strategies implicitly assume that their hedge portfolio will remain closely aligned with the liability across time.

The reality is not so simple. 

A hedge portfolio designed to precisely match the liability’s market risk factors may have difficulty generating the returns needed to maintain parity—and could require the sponsor to provide additional capital at some point. But attempting to offset this return shortfall with a larger portfolio of return-seeking assets essentially defeats the purpose of building a precise hedge.   

The solution is straightforward, although somewhat counter to the prevailing industry trend of ultra-precise hedge design. A more flexible, diversified hedge portfolio that includes traditional fixed income components, as well as structural diversifiers and return enhancements, can provide a better balance between low volatility and return generation—the two key objectives of a successful hedge strategy. 

We suggest taking three key steps to build an effective and efficient liability hedge program:

  1. Focus active credit management on minimizing losses from downgrades and defaults.
  2. Diversify into high quality spread sectors that improve resilience against credit downturns.
  3. Use higher-yielding extended hedge sectors to generate returns.

Taking any one of these actions in isolation would be positive, but a hedge program that incorporates all three may be optimal (see Appendix). It can potentially deliver an effective mark-to-market hedge relative to the liability as markets move, prove more resilient to credit shocks that might otherwise degrade funded status and earn enough across time to compensate for unavoidable structural headwinds.

Understanding the shortcomings of the traditional LDI model

Most traditional LDI portfolios precisely calibrate the hedge strategy to match the liability across key market risk factors, including duration, credit spread, curve and convexity. This approach invariably leads to portfolios that are dominated by long-duration corporate bonds, and while such bonds are critical to building an effective hedge, their lack of flexibility with respect to other risk factors is limiting. To tighten the fit to the liability, Treasuries or interest rate derivatives are often needed.

On paper, these strategies closely match multiple risk factors, but in the real world they can fail to keep pace with liabilities across time. Why? Because the risk factor models used to align assets and liabilities are only as good as the factor sets they include, and—when it comes to pension hedging—those factor sets are incomplete.

Hedge assets and liabilities do indeed share the risk factors outlined above, but they are also subject to additional risks:

On the asset side: Using a corporate yield curve as the basis for calculating the present value of liabilities creates a problem. Any portfolio of corporate bonds designed to match this curve will be subject to downgrades and defaults, leading to a loss in value—but the liability side will be unaffected by these losses, which means that a gap between the two sides will emerge over time (Exhibit 1).

On the liability side: Two actuarial risks on the liability side cannot be effectively hedged with financial assets, creating an inherent challenge. The first risk is a consistent underestimation of longevity as participants tend to live longer over time; the second is an inability to accurately predict participants’ behavior. Both factors almost always increase the liability in ways that a fixed income portfolio cannot match.

These structural gaps between assets and liabilities have always existed, but they were seen as inconsequential when plans were poorly funded and hedge portfolios were small. However, for today’s well-funded pensions, which have large hedge portfolios, even modest headwinds can significantly impact the success of their long-term strategies.

Taking a more flexible, diverse approach to hedge portfolio design

Moving away from this industry norm requires actively recalibrating—and optimizing—the hedge portfolio.

Step 1: Focus active LDI managers on minimizing credit losses

Allocators generally regard diversification across manager styles as a positive feature, but not all investment styles are equally well suited to a large hedge program. In the past, when plans were less well funded and hedge portfolios were more modestly sized, many allocators gave their LDI managers broad market benchmarks that included Treasury bonds as a means of forcing some risk diversification into the broader asset allocation. In other cases, allocators selected managers with high alpha and tracking error expectations so that their excess returns could help recapitalize underfunded plans. From today’s vantage point, with plan funding at high levels and smaller return-seeking portfolios, these specific manager objectives are less important.

So what is the alternative? Certainly not passive management. Historically, passive long credit portfolios have underperformed liabilities by approximately 40–50 basis points (bps) per year. It does not take very many years for these shortfalls to compound into a meaningful funding gap (Exhibit 2). Reducing this headwind is critical to the long-term success of pension plans’ hedge programs. Active managers have generally improved performance vs. passive strategies.

This is where style becomes important. Credit managers that generate outperformance by tilting their portfolios toward riskier, higher yielding sectors of the corporate bond markets could present a genuine concern for plan investors. While such strategies may do well in benign credit environments, they will be more likely to underperform in a credit downturn, when downgrade activity spikes. For such managers, one year of outsized losses can erase many years of positive alpha—and for de-risked pension plans, loss of funding makes it much more difficult to meet future liabilities.

Today’s well-funded plans may be best served by active managers that emphasize disciplined credit research and careful security selection—and can diversify across higher quality fixed income sectors without reducing yield. This style bias may forgo some excess return potential, but it is also more likely to result in portfolios that can avoid a greater share of credit downgrades and defaults.

Step 2: Diversify away from corporates into other high-quality spread sectors

LDI strategies are usually built from two market sectors: corporate bonds and Treasuries. While this type of two-factor portfolio can be broadly effective, these strategies turn out to be somewhat inefficient because they ignore another highly useful fixed income sector hiding in plain sight: securitized bonds. It seems hard to believe that such an oversight could occur given how much time and effort has been spent on LDI strategy over the past decade, but it is true nonetheless.

Years ago, when most pension investors made initial forays into long-duration fixed income, they were moving away from a traditional “core” strategy comprised of three roughly equal components: Treasuries, investment-grade credit and mortgage-backed securities (MBS) issued by government-sponsored enterprises (GSEs). The pivot to long duration effectively canceled out agency-backed MBS, which then almost exclusively comprised securities that offered low duration and negative convexity—two attributes that made them unsuitable for hedging pension liabilities.

Since the global financial crisis (GFC), however, a deep and liquid market has emerged among certain categories of agency-backed, AAA-rated securitized bonds. These high-quality bonds incorporate pre-payment protection and yield maintenance provisions, which—in combination—ensure both long duration and positive convexity. This “long securitized” market offers a pair of valuable attributes: risk diversification and return potential.

Accessing an ultra-high quality asset class that offers compelling yield and protection from credit risk can be useful for any pension plan, but the benefits afforded by these securitized bonds are particularly powerful for plans with large hedging programs. Thanks to their GSE guarantees, long securitized bonds have little or no credit risk, so they can be substituted for corporate bonds—thus eliminating the risk of losses from downgrade or default. And unlike Treasuries, which also sidestep credit risk (but do so at the price of a much lower yield), long securitized bonds offer yields similar to high quality corporates.

How much long securitized fixed income does it make sense to hold, especially within a broader hedging program that already contains both long corporate bonds and Treasuries? Although the answer will vary depending on the relative yields across the three fixed income sectors, our analysis suggests that pension allocators can safely dedicate approximately 20%–30% of their overall hedging program to long securitized bonds.

At this weighting, a long securitized sleeve will be sufficiently large to counterbalance credit risk from corporates and low yields from Treasuries, while still allowing the overall hedge portfolio to maintain an appropriate balance of potential return and low tracking error.

Pension investors can add structural allocations to long securitized bonds in two ways:

  • As a standalone asset class alongside corporate bonds and Treasuries
  • By using active LDI managers that maintain a consistent structural allocation within their investment portfolios.

For standalone long securitized allocations, it is possible to incorporate modest use of Treasury futures to reach and maintain a target duration across time, making it easier to incorporate long securitized bonds into a pension plan’s broader hedging strategy. Pension investors may also want to look for managers in this sector that can use their skill in securitized credit, further improving the potential yield and diversification of the hedge program.

For traditional LDI managers using long securitized bonds within their portfolios, it will be critical that they demonstrate an ability to evaluate relative value between long corporate credit and long securitized debt. This skill will be particularly valuable during periods of tight corporate credit spreads, when LDI managers can use long securitized holdings as a safety valve and avoid buying assets trading at rich valuations.

Step 3: Use higher yielding strategies to improve returns and diversification

Diversifying a hedge portfolio efficiently—relative to the traditional core holding of long-term corporate bonds—can follow two paths. The first path involves using strategies that seek to reduce credit risk concentration while preserving as much yield as possible. The previously discussed use of long securitized bonds is an example of this approach.

The second path requires using strategies that can comfortably outearn the liability without increasing risk to the point of inefficiency.  While any number of investment strategies might fit this description, we think prudent investors ought to focus on asset classes that have fundamental “liability-like” attributes, such as a predictable level of duration, credit spread and yield. High returning assets that lack these features are certainly not out of bounds for pensions—they simply belong in the return-seeking portfolio, not the hedge portfolio.

High yield bonds are one obvious candidate for this role—and specifically, the higher quality segment of the high yield universe (bonds rated BB and B). These are fixed-rate corporate bonds with measurable duration and credit spread characteristics (and of course higher yields than the core investment-grade LDI portfolio). At the benchmark level, these well-defined risk factor characteristics allow high yield to be readily incorporated into a broader hedge program alongside more traditional hedge categories.

The presence of a dedicated high yield allocation has the benefit of directly offsetting one of the key structural shortcomings of traditional LDI, which is the persistent negative performance of so-called “fallen angels,” a moniker for downgraded corporate bonds that have lost their investment-grade rating.

Active high yield managers can acquire these securities after their loss of value. Further, high yield portfolios can benefit from the price appreciation that often comes when securities are upgraded from high yield to investment grade (aka “rising stars”). This continuous two-way flow of bonds into and out of the high yield market can be a driver of positive performance across time—one that active managers with the skill to underwrite these credits can potentially maximize (Exhibit 4).

While high yield is an obvious choice because of its close similarity to traditional LDI investments, other types of return-seeking diversifiers may be useful to consider as well. These options include corporate private placements, commercial mortgages, direct lending, mezzanine debt and core real assets. Each has pros and cons as a means of efficiently improving the returns of the hedge program (Exhibit 5).

Conclusion: A new, more flexible approach to structuring hedge portfolios

Diversifying a hedge portfolio can take two forms: It can be achieved via high quality assets that offer protection from credit risk at an attractive yield, and by using higher returning strategies whose risk characteristics are sufficiently similar so as to not render the overall hedge strategy ineffective.

In the first category, long-duration securitized bonds can serve as a useful enhancement to portfolios built using investment-grade corporate bonds and Treasuries. In the second category, a wide range of lending-based or income-producing asset classes can improve returns without generating excessive risk.  Far from being mutually exclusive, these approaches are, in fact, more powerful when combined and used alongside more traditional hedge portfolio components.

This is not an academic exercise. As more and more pension sponsors consider the possibility that defined benefit pensions may have an ongoing role to play in their retirement benefit packages, they need to be able to envision an allocation model capable of sustaining these plans in a risk-controlled way. For a well-funded plan with a large hedge portfolio, the heavy lifting is done—and all that remains is to restructure the hedge program and deliver an effective hedge as efficiently as possible.

APPENDIX: Illustrating the potential benefits of a diversified hedge program

Exhibit A applies the principles of hedge portfolio design outlined previously, using historical market data from 2001 to 2023. This was a period in which two factors—broadly declining interest rates and a significant credit crisis—drove liability outperformance. Given this context, we judge the relative success of hedge portfolios by their ability to stay as close as possible to the liability’s value.

Here, we present three different hedge portfolios, representing 100% of a plan’s assets and duration-matched across time to the liability—an approach that allows us to isolate the performance impact of credit risk exposure and returns relative to the liability:

  • Portfolio A represents a traditional LDI strategy comprised of 80% long corporate bonds and 20% long Treasury bonds.  This approach maintains a concentrated exposure to corporate credit risk as a means of reducing tracking error.
  • Portfolio B diversifies the hedge portfolio away from corporate credit by substituting long securitized bonds for long corporate credit at a 20% weighting, while keeping the 20% allocation to long Treasury bonds unchanged.
  • Portfolio C seeks to increase returns by adding modest allocations to return-focused hedge assets—in this case, 5% to high yield and 5% to direct lending.

The traditional LDI portfolio delivers the lowest annualized funded status volatility, but it also provides the lowest return and—at the end of the period—demonstrates the worst funded-status outcome. Adding long securitized debt modestly increases funded status risk but results in a materially better funded-status outcome. Further diversifying the portfolio with higher returning, credit-oriented strategies improves the portfolio’s efficiency in both dimensions, i.e., higher returns and lower surplus volatility.

Although this stylized, historical example does not settle the question of how to build a better hedge portfolio, the results demonstrate the real-world benefits of diversification and excess returns over time.

Each data point indicates a sample plan that started at 100% funded on a U.S. GAAP basis at the start of the projection. Liabilities are valued on an  AA-rated corporate pension discount curve. Active fees are assumed 20bps/year. Passive fees assumed 5bps/yr. PBGC premiums at the start of the projection set at 2023 actual levels and estimated after by applying inflation indexing of 2.5% (where applicable). Analysis assumes average USD 115,000 pension benefit obligation/participant based on analysis of Form 5500 data. Annual administrative costs of USD 40/participant paid out of plan assets.