How do pension funds use derivatives overlays in LDI to hedge interest rate risk without selling their return-seeking assets?

A derivatives overlay allows a pension fund to maintain its return-seeking portfolio (equities, alternatives, credit) while layering on interest rate derivatives that provide the duration needed to hedge liabilities. This separates the hedging decision from the return-generation decision.\n\nCore Concept:\n\nWithout an overlay, achieving a dollar duration match requires physically holding long-duration bonds, crowding out growth assets. An overlay uses interest rate swaps, futures, or swaptions to synthetically extend portfolio duration.\n\n`mermaid\ngraph TD\n A[\"Pension Assets $1.2B\"] --> B[\"Physical Portfolio
60% Equity / 30% Credit / 10% Alts
Duration ~ 4 years\"]\n A --> C[\"Derivatives Overlay
Receive-fixed swaps
Adds ~14 years duration\"]\n B --> D[\"Total Effective Duration
~18 years\"]\n C --> D\n E[\"Liabilities PV $1.1B
Duration ~18 years\"] --> F{\"Duration Gap?\"}\n D --> F\n F -->|\"Matched\"| G[\"Interest Rate Risk
Hedged\"]\n`\n\nImplementation with Receive-Fixed Swaps:\n\nSterling & Associates Pension has:\n- Assets: $1.2B, physical duration = 4.0 years\n- Liabilities: $1.1B, duration = 18.0 years\n\nTarget asset BPV = Liability BPV:\nLiability BPV = $1.1B x 18 x 0.0001 = $1,980,000\nPhysical BPV = $1.2B x 4 x 0.0001 = $480,000\nRequired overlay BPV = $1,980,000 - $480,000 = $1,500,000\n\nIf a 20-year receive-fixed swap has a BPV of $15,000 per $1M notional:\nNotional needed = $1,500,000 / ($15,000 / $1M) = $100M notional\n\nInstruments Used:\n- Interest rate swaps (most common): receive fixed / pay floating to add duration\n- Treasury futures (bond futures): long position adds duration; requires margin and rolling\n- Swaptions: provide conditional duration hedging and protect against rate decreases\n- Gilt repos (UK schemes): leverage physical gilt positions to free up capital\n\nCollateral and Liquidity Risks:\nThe overlay requires posting collateral (initial and variation margin). When rates rise sharply, the swaps lose mark-to-market value, triggering collateral calls. The 2022 UK gilt crisis demonstrated how leveraged LDI strategies can face liquidity spirals if collateral buffers are insufficient.\n\nKey Advantages:\n- Maintains exposure to return-seeking assets\n- Precise duration matching without restructuring physical portfolio\n- Can be adjusted dynamically as liability profile changes\n- Lower transaction costs than physically rebalancing bonds\n\nPractice overlay sizing calculations in our CFA question bank.