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Should You Hedge Currency Risk in a Pension Plan?

Six questions institutional investors should ask to determine whether currency hedging makes sense for their portfolio.

By Bradley S. Smith | Updated on March 17, 2016
2016 promises to be challenging for U.S.-based pension plan sponsors and other institutional investors. We expect markets outside the United States to offer better investment opportunities and valuations this year than domestic markets will offer. However, U.S. investors who seek to capitalize on these opportunities need to consider the currency impacts associated with building a global portfolio when making asset-allocation decisions.

Traditionally, few U.S.-based pension plan sponsors have paid much attention to the impact of currency risk on their portfolios. Many have taken a passive approach and deferred to their portfolio manager on all foreign exchange (FX) risk management decisions. But the trend in currency risk is toward increased volatility. Currency risk is an overwhelming source of volatility for global fixed income, and the currency risk associated with global equity exposure is a meaningful contributor to total investment risk.

This isn’t a problem corporate pension plan sponsors can expect to go away. If currencies are as volatile as expected, failure to effectively manage FX risk will potentially introduce uncompensated volatility into a plan’s asset portfolio, which will reduce the expected efficiency of the investments.1

Like most U.S. institutional investors, pension plan sponsors generally hold their fund’s foreign asset classes in an unhedged fashion. This means they receive a total return on investment that is a combination of, first, the underlying asset’s returns in terms of the local (foreign) currency and, second, any returns resulting from the change in value of the foreign currency relative to the investor’s home currency.

"An institutional investor that analyzes only total returns is masking the impact that foreign currency fluctuations are having on its investments' performance."Obviously, the currency impact on a U.S. pension plan in a given period can be either positive or negative, depending on the direction in which the U.S. dollar moves relative to the basket of foreign currencies held in the plan. A strong dollar means that foreign currencies have depreciated, reducing the U.S. dollar-based value of the foreign assets’ returns; we’re experiencing that now as the dollar flexes its muscle relative to the euro, yen, and other major currencies. On the flip side, when the dollar is weak, it has a positive impact on foreign-asset returns.

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