What is a liability-hedging portfolio, and how is it constructed to immunize a pension plan's funded status against interest rate movements?

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AcadiFi · Accepted Answer

The liability-hedging portfolio (LHP) is the portion of a pension fund's assets specifically designed to move in lockstep with the plan's liabilities when interest rates change. Its goal is to neutralize the impact of rate movements on the funded ratio.

**Construction Principles**

**Principle 1 — Duration Matching**

The LHP's effective duration must match the liability's effective duration. For a pension with liability duration of 14.5 years, the LHP should also have a duration of ~14.5 years.

But duration matching alone is insufficient. A parallel shift hedge works, but yield curves twist, steepen, and flatten.

**Principle 2 — Key Rate Duration (KRD) Matching**

Match the liability's sensitivity at multiple points along the curve:

| Maturity Point | Liability KRD | LHP KRD |
|---|---|---|
| 2-year | 0.6 | 0.6 |
| 5-year | 1.3 | 1.4 |
| 10-year | 2.9 | 2.8 |
| 20-year | 5.1 | 5.0 |
| 30-year | 4.6 | 4.7 |
| **Total Duration** | **14.5** | **14.5** |

This ensures the hedge works under non-parallel yield curve movements.

**Principle 3 — Credit Spread Matching**

Since pension liabilities (under US GAAP) are discounted at AA corporate yields, the LHP should contain AA-rated corporate bonds to match the spread sensitivity. If the LHP holds only Treasuries, a widening of credit spreads would reduce liability values (good) without affecting the LHP (bad) — creating a tracking error.

**Instrument Selection:**

| Instrument | Role in LHP | Advantage |
|---|---|---|
| Long corporate bonds (AA) | Core holding | Matches discount rate |
| Treasury STRIPS | Fill ultra-long duration gaps | Zero-coupon = precise maturity targeting |
| Interest rate swaps | Extend duration without cash outlay | Capital-efficient |
| Treasury futures | Tactical duration adjustment | Liquid, low cost |
| TIPS | If liabilities are inflation-linked | Matches real rate sensitivity |

**Worked Example — Evergreen Pension Fund ($2.4B liabilities, $2.0B assets):**

LHP allocation (60% of assets = $1.2B):

| Instrument | Allocation | Contribution to Duration |
|---|---|---|
| AA long corporates (15-25 yr) | $650M | 8.2 years |
| Treasury STRIPS (25-30 yr) | $200M | 3.8 years |
| Receive-fixed swaps (30 yr) | $200M notional | 2.3 years |
| TIPS (10 yr) | $150M | 0.9 years |
| **LHP Total** | **$1.2B** | **15.2 years** |

The LHP duration of 15.2 slightly exceeds the liability duration of 14.5 — a deliberate decision because the plan is underfunded and benefits from a small positive duration bet (rates falling increases assets more than liabilities, improving the funded ratio).

**Monitoring:**

- Rebalance KRDs quarterly or when key rate deviations exceed ±0.3 years at any maturity.
- Track the **hedge ratio** = LHP duration × LHP value / Liability duration × Liability value.
- A hedge ratio of 1.0 is fully immunized; Evergreen targets 0.85 (partial hedge to allow some return seeking).

Our CFA Level III fixed income LDI course covers immunization strategies in depth.

What is a liability-hedging portfolio, and how is it constructed to immunize a pension plan's funded status against interest rate movements?

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