Hedging interest rate risk for pension schemes: Optimization and effectiveness

Abstract

Efficiently managing hedging portfolios on behalf of pension funds is key in achieving the target hedging strategy, which can significantly impact coverage ratios. A new optimization approach to fixed income portfolio management for pension funds is proposed that finds interest rate risk hedging strategies while incorporating additional requirements. These are relevant requirements for pension funds such as country allocations, low transaction costs and reasonable investment costs. In doing so, pension fund regulations and common practices are investigated in a rigorous mathematical framework. The hedging strategies are shown to perform well when back-testing. In addition, simulation of the interest rate and cash flows in a Defined Benefits pension scheme displays the good performance of the strategies. These strategies are further tailored to specific pension funds by considering the trade-off between yield and risk, which could contribute to increasing a pension fund’s coverage ratio. Alternatively, a procedure is also proposed to generate more diversified albeit less optimal hedging portfolios using the optimization approach.