Practical Applications of Maximizing Capital Efficiency in US Defined Benefit Pension Plan Immunizing Portfolio Construction Using Derivatives and a Power Law Relationship

Abstract

In Maximizing Capital Efficiency in US Defined Benefit Pension Plan Immunizing Portfolio Construction Using Derivatives and a Power Law Relationship, from the April 2022 issue of The Journal of Portfolio Management, Scott McDermott of Goldman Sachs Asset Management explores the challenges of asset-liability risk management for the portfolios of defined-benefit pension plans. He first divides a plan’s portfolio into two components: one allocated to managing asset-liability matching (an “immunizing portfolio” or “IP”) and a second allocated to outperform the plan’s liabilities over time (a “growth portfolio” or “GP”). McDermott argues that an IP should be managed dynamically, to maximize capital efficiency, and that, when capital is scarce, managing interest rate risk takes priority over managing credit risk. However, the proportion of capital used for managing credit risk should increase as a plan’s funding status improves. The author proposes a power law relationship between the hedge ratios for interest rate risk and credit risk. He recommends using interest rate and other derivatives to maximize the efficiency of the strategy.

The author thinks all managers should ask the following question: Which is riskier, interest rate or credit spread risk? Which has the most volatility, Treasury yields or corporate spreads? Which should we focus on hedging first, and how should we make the trade-off? His research provides fund managers with an approach to answer these questions and develop a more efficient hedging program.