Tail risk hedging strategies for corporate pension plans

Abstract

Pension plan sponsors tend to think of their asset risks and liability risks separately. Indeed, most risk management strategies employed by pension plans focus primarily on the main sources of liability risk, especially managing the sensitivity of the plan's funded status to interest rates. A common and popular strategy is to use interest rate swap overlays to partially immunize the plan's funding status against future changes in interest rates. The simple liability-driven investment (LDI) strategy is very transparent and its impact is to reduce the plan's overall funding volatility without moving large fractions of a plan's assets to bonds and thereby reducing the plan's expected return. In this article, we provide an option-theoretic analysis of the typical LDI approach to pension plan risk management, and we show that the LDI strategies really consist of two separate component strategies: (i) a tail risk hedging strategy that limits downside risk to declining interest rates, and (ii) a financing strategy that limits the plan's net upside in rising interest rate environments. We then explicitly quantify both the associated implicit costs paid for tail risk insurance and the implicit premiums received to finance the latter. This framework allows us to explore alternative cost and premium equivalent solutions that offer quite different risk return profiles to the pension plan. We demonstrate that an approach that recognizes both the interest rate risk on the liability side and the equity risk on the asset side of the pension plan's balance sheet, and integrates these risk factors into a common framework, is more effective than a typical liability-centric LDI approach. Specifically, we show that the optimal tail risk hedging solution reduces the tail risk hedging costs when compared with simple LDI approaches that are aimed at interest rate risk and liability risk only. © 2011 Macmillan Publishers Ltd.