We have identified a number of approaches to hedging these complex exposures, including:

Projecting the liability cash flows using the approach described above, but applying the plan's floor to each projected crediting rate and hedging the changes in duration as each rate moves above or below the floor. This involves careful monitoring of the forward rates as each nears the level of the floor. This may be the most pragmatic and simple solution, particularly when the floor is low or the cash balance component represents only a small proportion of the overall liabilities being hedged.
Using a Monte Carlo simulation to value the plan optionality and hedging the delta of this optionality with standard market instruments. Put simply, if the model assesses a 50 percent chance that rates will take the interest crediting rate above (or below) the floor, a pragmatic approach is to split the difference. Such a method should be considered for large cash balance plans, particularly when the level of the floor is close to the projected forward rates. However, the market calibration of such a model can be complex, particularly given the lack of liquidity in Treasury-based option models (although a proxy may be achieved by taking volatility assumptions from the swaptions markets). The plan retains the short gamma position under this approach, but the effect will be smoother than under the previous approach.
Purchasing a series of payer swaptions struck at the levels of the floor when the floor is much higher than the projected interest-crediting rate, while hedging liabilities similar to a traditional defined-benefit plan (positive duration). The purchased payer swaptions will reduce the duration of the asset portfolio to match that of the liabilities should interest rates rise substantially. Similarly, when the floor is much lower than the projected crediting rate, the plan sponsor can purchase a series of receivers struck at the level of the floor, while hedging liabilities like a cash balance plan (no duration). The purchase of receiver swaptions will increase the duration of the asset portfolio to match that of the liabilities should interest rates fall substantially. While such a strategy may provide the optimal hedge, as it removes the short gamma position, it can be extremely costly, particularly when the strike of the floor is close to the current implied interest-crediting rate.

For plan sponsors that have introduced cash balance plans as an alternative to more traditional defined-benefit plans, the challenges of hedging the interest rate sensitivities that these plans introduce are complex but not insurmountable. We recommend that every plan sponsor transitioning to a cash balance plan should have a strong understanding of the unique market risks these plans present.

Instant Insights /

Risk Management Solutions for Cash Balance Plans

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