Interest Rate Swap-Based Hedging Strategies for Pension Plan Sponsors

Pyramis Global Advisors | Research Paper

By Michael J. Senoski, FSA, CFA Vice President and LDI Investment Director Pyramis Global Advisors

FOURTH QUARTER 2008 FOURTH IN A SERIES Interest Rate Swap-Based Hedging Strategies for Pension Plan Sponsors

November 30, 2008—The use of interest rate swaps 1 as part of a strategy to hedge the interest rate risk embedded in a pension plan’s liability structure raises a number of issues, including the use of leverage, the valuation and posting of collateral, counterparty risk, and basis risk. Basis risk arises from the imperfect correlation between the cash bond market interest rates that are the regulatory standard for measuring pension liabilities, and swap market rates. The purpose of this paper is to review the regulatory framework for measuring pension liabilities, examine the historical record of cash bond market rates relative to swap rates, and evaluate the effectiveness of swap- based hedging strategies in reducing the tracking error between pension asset and liability returns of a sample group of pension plans. We will demonstrate that the potential beneﬁ ts of swap-based hedging strategies are clear and measurable, notwithstanding the basis risk that is inherent in such strategies.

Regulatory Framework 1980s that led to the issuance of the fi nal version of FAS The move toward liability driven investing (LDI) is motivat- 87 in December 1985. The notional value of outstanding ed largely by both the fi nancial accounting and minimum interest rate swaps was a mere $80 billion at that time funding requirements that apply to pension plans. In (compared with $309 trillion in December 2007) and both cases, the basis for measuring pension liabilities is the process leading to the standardization of interest rate grounded in the cash bond market, not the interest rate swap contracts had only just begun. The fi nal version of swap market. This is an important distinction. Understand- FAS 87 adopted the concept of settlement with respect ing its signifi cance and taking it into consideration during to the selection of the discount rate used to measure the design phase will result in an LDI strategy that’s better pension obligations. In estimating the cost of a settlement, informed and more effective. plan sponsors could take into consideration the “rates of return on high-quality fi xed-income investments currently Financial Accounting available and expected to be available during the period to The possibility of using a swap curve rather than the cash maturity of the pension benefi ts,” as stated in FAS 87. bond market as the basis for measuring pension liabilities was not an option available to the architects of Statement In 1993, the SEC issued guidelines with respect to 2 of Financial Accounting Standards No. 87 (FAS 87). the interpretation and application of the discount rate The interest rate swap market was only in nascent form provisions of FAS 87. These guidelines referred to the during the deliberation and discussion phase in the early rates available on AA-rated bonds as an appropriate basis

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084742_01_bro_Research.indd 1 12/4/08 2:52:38 PM for FAS 87 discount rate determinations. accounting, the discount rates used for because you cannot prefund or defease that In 1994, Salomon Brothers (now part of minimum funding calculations are based obligation using a swap in association with Citigroup) constructed and published a on the cash bond market. In particular, any derivatives position. These arguments pension discount curve to help plan discount rates for minimum funding are may or may not have refl ected the thinking sponsors comply with the SEC guidelines. derived from cash market rates applicable to on this issue of the architects of the PPA. Currently updated on a monthly basis, the the top three quality levels, AAA, AA, and A. Citigroup Pension Discount Curve 3 has What is noteworthy here is that the size and Cash Market Rates Versus Swap Rates been adopted by a large number of plan signifi cance of the interest rate swap market The starting point for developing a swap- sponsors as the basis for pension liability in 2006, when the PPA was passed, was based strategy for hedging the exposure of measurements. In addition to the Citigroup obviously far greater than it was when FAS a pension plan’s funded position to interest curve, other service providers and plan 87 was adopted. Yet there is no evidence to rate risk is an understanding of the relation- sponsors have developed methods for suggest that the use of a swap curve as a ship between cash market bond rates and creating an AA corporate bond yield curve basis for discounting pension liabilities was swap rates. Focusing on the relationship for FAS 87 pension liability measurements. ever a serious consideration. In fact, there is between cash market spreads and swap no mention at all of a swap curve in either a spreads to Treasuries facilitates this under- Minimum Funding Requirements February 2005 white paper by the Treasury standing. Due to the linkage between swap The federal minimum funding requirements Department on the subject of pension rates and Libor, and because Libor is the applicable to defi ned benefi t pension plans discounting or a January 2006 update borrowing rate across banks that typically were amended by the Pension Protection of the same. carry an AA credit rating, we can control for Act of 2006 (PPA). An issue of particular differences in spread due to credit quality concern to all the participants in the legislative A report on the subject of discount rates pre- by comparing AA spreads in the cash process, including the Treasury Department, pared by Ryan Labs, Inc., in 2001 as part of market to swap spreads. The chart below House, and Senate, was the methodology for a research project sponsored by the Society compares historical 10-year AA spot rate determining the interest (discount) rate for of Actuaries addressed in some detail the spreads extracted from the aforementioned measuring pension liabilities. Consequently, pros and cons of the use of the swap curve Citigroup curve to 10-year zero coupon a considerable amount of time and effort was as a basis for measuring pension liabilities. swap-rate spreads. devoted to this particular issue during the Prominent among the cons is the argument deliberations leading up to passage of the that the interest rate swap is primarily a tool Over the period from the inception of the fi nal legislation. The outcome of the process for managing or hedging yield spread risk, Citigroup curve in 1995 through September was a yield curve approach for discounting but not suitable for managing total price or 2008, 10-year AA spot rate corporate bond pension liabilities that was similar in some return risk. A second argument is that you spreads exceeded swap spreads by an critical respects to the fi nancial accounting cannot measure (market price) the value of average of more than 50 basis points. The methodology. Like the rates used for fi nancial a pension obligation using swap-based rates difference in basis points narrowed to less

Exhibit 1: 10-Year Spot Rate Spreads AA Corporate Spreads Swap Spreads 500

400

300

200

100

Spread to Treasuries (bps) Spread to Treasuries 0 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Mar-96 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Date Sources: Lehman Live, Citigroup, Pyramis Global Advisors

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084742_01_bro_Research.indd 2 12/4/08 2:52:39 PM than 20 basis points throughout much of 2005, while ballooning to well over Exhibit 2: Average Excess Spread—AA Corporate Spreads Over Swap Spreads 250 basis points in September 2008. 90 80 Similar results apply across the entire spot 70 rate curve. Exhibit 2 shows the average of 60 the difference between the AA corporate 50 bond spreads and swap spreads over the 40 entire (out to 30 years) spot rate curve over the September 1995 through September 30 2008 period. Generally increasing with Excess Spread (bps) 20 maturity, the average difference between 10 spot rate corporate bond and swap spreads 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 ranges from roughly 20 basis points at the Maturity front end of the curve up to 80 basis points for longer maturities. Sources: Lehman Live, Citigroup, Pyramis Global Advisors as of September 30, 2008

A number of reasons have been offered to explain why swap spreads are less than Exhibit 3: Comparative Spot Rate Curves—September 30, 2008 spreads on AA-rated bonds of the same maturity. Common among them is that the Citigroup AA Curve Swap Curve amount at risk to the counterparty on the 9 receive fi xed side of a swap transaction 8 is limited to the mark-to-market value, if positive, of the swap based on the notional 7 value of the swap. Because there is no 6 exchange of principal in a swap transaction, 5 this amount is limited to the present value Yield 4 of the difference between the remaining 3 coupon payments and hypothetical coupon 2 payments based on the receive fi xed rate 1 0 applicable to a current coupon swap of 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 comparable tenor (maturity). This amount is Maturity typically far less than the amount at risk to the holder of an otherwise comparable cash Sources: Lehman Live, Citigroup, Pyramis Global Advisors as of September 30, 2008 market bond. Some of the other reasons relate to the level of hedging activity, the level and shape of the yield curve, and Our review and discussion of cash market and Washington Mutual. A comparison collateral and other credit enhancement bond and swap spreads would lead us of Citigroup curve rates and swap rates features of swap contracts. to believe that discount rates based on over different time periods yields similar the Citigroup curve would be higher than results, although the average differential Of particular interest to plan sponsors swap rates. It turns out that this is exactly is substantially narrower. It also seems considering a swap-based hedging strategy the case. Rates at every point across the reasonable to expect that a comparison of is the relationship between liability discount Citigroup curve exceeded comparable swap rates with the pension liability discount rates and swap rates. As noted above, swap rates with an average differential of curves developed by other service providers the Citigroup Pension Discount Curve has over 290 basis points. This differential is and plan sponsors, and the monthly yield gained widespread acceptance among plan unusually large and refl ects the dramatic curve developed by the Treasury for federal sponsors as a basis for calculating pension widening of credit spreads in the cash minimum funding calculations, would liabilities in accordance with fi nancial bond market that occurred as a result of yield similar results. accounting standards. Exhibit 3 compares the seizure of the credit markets in the the Citigroup Pension Discount Curve as of wake of the bankruptcy or near collapse of September 30, 2008, with corresponding several high-profi le issuers, including Fannie Lehman Brothers zero coupon swap rates. Mae, Freddie Mac, AIG, Lehman Brothers, For Institutional Use Only 3

084742_01_bro_Research.indd 3 12/4/08 2:52:39 PM Since swap rates are lower than cash bond Correlations across the intermediate market rates, the fact that discount rates for 2-, 5-, and 10-year maturities ran well fi nancial accounting and minimum funding above 0.9 for most of this period, while the calculations are based on cash bond market 30-year maturity correlation ranged between rates and not swap rates should not be of 0.8 and 0.9 for an extended period. What any particular concern to a plan sponsor. is most striking is the dramatic decline in On the contrary, it is easy to imagine that correlations across all maturities that began most plan sponsors welcome the near-term in mid-2007 as the impact of the subprime benefi ts, such as lower pension liabilities, mortgage crisis on the availability and cost pension expense, and contributions that of credit intensifi ed. In the summer of result from the use of the higher rates. To 2008, correlations across 10- and 30-year plan sponsors considering a swap-based maturities actually dipped into negative strategy for hedging the exposure of their territory. As has generally been the case plan’s funded position to interest rate risk, during periods of fi nancial stress, including the correlation between cash bond market the Russian debt crisis in 1998, the rates and swap rates will be of much aftermath of 9/11 in 2001, and the Enron greater interest. and WorldCom defaults in 2002, there was a signifi cant widening of cash market Exhibit 4 illustrates the correlation between spreads relative to swap spreads as these month-end 2-, 5-, 10-, and 30-year Citigroup events unfolded. spot rates and the corresponding Lehman Brothers zero coupon swap rates over rolling 36-month periods from December 1998 through September 2008.

Exhibit 4: Rate Correlations 2-Year Zero 10-Year Zero 5-Year Zero 30-Year Zero 1.000

0.800

0.600

0.400

0.200

Correlation 0.000

-0.200

-0.400

-0.600 Jun-00 Jun-03 Jun-06 Mar-01 Mar-04 Mar-07 Sep-99 Sep-02 Sep-05 Sep-08 Dec-98 Dec-01 Dec-04 Dec-07 Three Years Ending

Sources: Lehman Live, Citigroup, Pyramis Global Advisors

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084742_01_bro_Research.indd 4 12/4/08 2:52:40 PM Tracking Error Exhibit 5: Tracking Error At the end of the day, it is the performance 2-Year Zero 10-Year Zero of the swap-based hedging strategy relative 5-Year Zero 30-Year Zero to plan liabilities that is of greatest interest 25 to the plan sponsor. More useful even than the correlation statistic in this regard is the 20 tracking error of swap returns relative to liability returns. It is a relatively straightforward exercise to transform a time series of cash 15 and swap market spot rates into their respective time series of spot rate returns, and the tracking error between them. 10 Exhibit 5 illustrates the annualized tracking Error % Tracking

error of Lehman zero swap rate returns 5 relative to Citigroup spot rate returns over rolling 36-month periods for the same time series of rates described above. 0

The tracking errors across the two- and Jun-00 Jun-03 Jun-06 Mar-01 Mar-04 Mar-07 Sep-99 Sep-02 Sep-05 Sep-08 fi ve-year maturities never rise above 1% and Dec-98 Dec-01 Dec-04 Dec-07 Three Years Ending 2%, respectively, before spiking in September 2008 as the credit squeeze intensifi ed. This is Sources: Lehman Live, Citigroup, Pyramis Global Advisors due to the generally high correlations noted above, as well as the relatively low durations Exhibit 6: Annualized Tracking Error at these maturities. For the 10-year maturity, Plan A Plan B Plan C Plan D Plan E tracking error periodically rises above the 3% 10 level, and the upward drift since mid-2007 is especially pronounced. A totally different picture emerges for the 30-year maturity. After 8 holding steady at around 10%, tracking error rose steadily for the next three years, peaking 6 above 23% before descending to roughly 6% over the next three years. Since mid-2007, 4 this fi gure has spiraled upward to over 15%. % Tracking Error % Tracking While our focus until now has been on 2 individual maturities, we are most interested in overall plan results. We can accomplish this 0 by creating a portfolio of funded 4 zero coupon swaps that is cash fl ow matched on an annual Jun-00 Jun-03 Jun-06 Mar-01 Mar-04 Mar-07 Sep-99 Sep-02 Sep-05 Sep-08 basis against the projected stream of benefi t Dec-98 Dec-01 Dec-04 Dec-07 payments that represent plan liabilities. Just Three Years Ending as above, we can then construct a historical Tracking Error time series of swap portfolio returns and plan liability returns (by assuming a stationary Plan Duration Minimum Maximum Average plan population), and observe the resulting A 10.1 1.4% 6.3% 4.2% tracking error. Exhibit 6 illustrates such B 10.6 1.5% 6.5% 4.4% annualized tracking error over rolling C 12.7 1.8% 7.5% 5.1% 36-month periods from January 1996 D 12.8 1.9% 7.8% 5.4% through September 2008 for fi ve pension plans of increasing duration from E 16.0 2.5% 9.5% 6.9% 10 to 16 years. Sources: Lehman Live, Citigroup, Pyramis Global Advisors

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084742_01_bro_Research.indd 5 12/4/08 2:52:41 PM These results appear reasonable based on would be willing to allocate their entire a conventional 60% equity/40% core the previous analysis and discussion. portfolios to a pool of funded zero coupon (Lehman Aggregate) fi xed-income strategy. A Tracking error persists, even with cash fl ow swaps to achieve these results. The decrease straightforward duration extension (Lehman matching, a consequence of the less than in expected portfolio performance on a total Long Government/Credit) strategy reduces perfect correlation between the cash market return basis would be unacceptable. There is tracking error by 1.0% to 1.3% across the and swap rates. As we would further expect, an almost infi nite variety of hedging strategy fi ve plans. As an alternative to the duration there is an increase in tracking error with possibilities. Many of these represent a clear extension strategy, a simple 40% overlay plan liability duration. And there is consider- and measurable reduction in risk without strategy using a 10-year bellwether swap able variation in tracking error over time, a negatively affecting expected return. The reduces tracking error by 1.6% to 1.9%, consequence of volatility in the relationship following table illustrates the potential risk while a 40% overlay using a 30-year between cash market and swap rates. reduction benefi ts of several very basic hedg- bellwether swap reduces tracking error ing strategies for our fi ve-plan universe. Each by 2.2% to 3.0%. None of these strategies The above results are indicative of the of the strategies maintains a 60% equity should have a negative impact on expected maximum potential benefi ts of a swap-based allocation, which is roughly equal to the return. In fact, some may argue that each hedging strategy in terms of risk reduction. average equity allocation for plan sponsors would be additive to performance on a Such benefi ts should, of course, be weighed in the United States. total-return basis. against the impact of the strategy on expected portfolio performance on a total Tracking error ranges from roughly 11% return basis. Few, if any, plan sponsors to 14% for our fi ve-plan universe based on

Asset Allocation Equity 60% 60% 60% 60% 0% Core FI 40% 0% 40% 40% 0% Long Duration FI 0% 40% 0% 0% 0% Swaps 0% 0% I II 100%

Plan (Duration) Tracking Error A (10.1) 10.9% 9.9% 9.3% 8.7% 4.2% B (10.6) 11.1% 10.1% 9.4% 8.8% 4.4% C (12.7) 11.9% 10.8% 10.1% 9.3% 5.1% D (12.8) 12.2% 11.0% 10.4% 9.5% 5.4% E (16.0) 14.0% 12.7% 12.1% 11.0% 6.9%

I 40% notional 10-year bellwether swap II 40% notional 30-year bellwether swap

Sources: Lehman Live, Citigroup, Pyramis Global Advisors as of September 30

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084742_01_bro_Research.indd 6 12/4/08 2:52:41 PM Conclusion Because of their unique features rela- transaction costs in the interest rate swap for measuring pension liabilities is grounded tive to cash market instruments, pension market compare favorably with cash bond in the cash bond market, not the interest rate plan sponsors concerned about fi nancial market transaction costs, and transacting swap market. Yet despite this risk, swap- statement or contribution volatility should in the swap market is relatively straightfor- based hedging strategies offer the potential carefully consider the potential benefi ts of ward once the appropriate documentation for a clear and meaningful reduction in risk. interest rate swaps. Over the short term, is in place. No other fi nancial instruments Moreover, this can be achieved with little interest rate risk is the most signifi cant can claim this unique blend of advantages if any negative impact on expected perfor- risk embedded in a pension plan’s liability within the LDI framework. At the same time, mance on a total-return basis. structure. Unfunded or leveraged interest plan sponsors should be aware of the basis rate swaps can be used as a hedge against risk that arises when interest rate swaps this risk while conserving plan capital for are used as part of a strategy to hedge the deployment in a variety of alpha-generating funding level of a pension plan to interest strategies such as absolute return or rate risk. This risk arises because the basis portable alpha strategies. Moreover,

1 An interest rate swap is an agreement to exchange interest payments for a specifi c period of time on a specifi ed amount of principal or notional value. The most common interest rate swap is a fi xed-for- fl oating coupon swap. The notional principal is typically not exchanged.

2 Statement of Financial Accounting Standards No. 87 establishes standards of ﬁ nancial accounting and reporting for an employer that offers pension beneﬁ ts to its employees.

3 The Citigroup Pension Discount Curve is intended as an AA corporate spot (zero coupon) rate curve at six-month intervals extending out to 30 years. It is not directly observable but is constructed based on a methodology developed by Salomon Brothers. This methodology adds option-adjusted AA spreads to an underlying Treasury curve.

4A swap paired with a cash investment that returns the payment of the ﬂ oating rate leg of the swap.

Michael J. Senoski, FSA, CFA, is vice president and LDI investment director at Pyramis Global Advisors. In these roles he contributes to product development, analytical support, and overall marketing for LDI strategies. He has more than 30 years of experience as a pension actuary advising deﬁ ned beneﬁ t plan sponsors on pension funding strategy and investment policy.

Note: You can access additional papers issued in the Pyramis series of white papers on contemporary investment topics, including “Liability Driven Investing: Setting the Benchmark,” “Pension-Liability Analy- sis: An Application of Fixed-Income Analytics,” and “Liability-Driven Investing: Risk Metrics and Strategy Evaluation,” which each focus on liability driven investing, at www.pyramis.com.

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084742_01_bro_Research.indd 7 12/4/08 2:52:42 PM About Pyramis Global Advisors Pyramis Global Advisors, a Fidelity Investments company, is an investment management ﬁ rm focused on serving corporate and public retirement funds, endowments, foundations, other institutions, and non-U.S. investors. Pyramis offers active and risk-controlled domestic equity, international equity, ﬁ xed income, real estate, and alternative disciplines.

Pyramis Global Advisors, LLC, is a registered investment advisor, and Pyramis Global Advisors Trust Company is a New Hampshire–chartered trust company and an investment manager. Both are Fidelity Investments companies. Pyramis products and services are presented by Fidelity Investments Institutional Services Company, Inc., a nonexclusive ﬁ nancial intermediary that is an afﬁ liate of Pyramis.

Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is no guarantee of future results.

For more information about Pyramis and the custom LDI solutions being developed for defi ned benefi t plans, please contact Michael Senoski, vice president and LDI investment director, Pyramis Global Advisors, at 401-292-4753, or Christian Pariseault, senior vice president and fi xed-income investment director, Pyramis Global Advisors, at 401-292-4744.

All trademarks and service marks presented herein belong to FMR LLC or an afﬁ liate, except for third- party trademarks and service marks, which belong to their respective owners. The views expressed herein are those of the individual contributors and do not necessarily represent the views of Pyramis Global Advisors.

Certain data and other information in this research paper were supplied by outside sources and are believed to be reliable as of the date presented. However, Pyramis has not and cannot verify the accuracy of such information. The information contained herein is subject to change without notice.

Pyramis does not provide legal or tax advice, and you are encouraged to consult your own lawyer, accountant, or other advisor before making any ﬁ nancial decision.

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