Hedging Duration Risk in Pension Plans

This diagram explains how a hedging strategy using bonds and interest rate swaps protects a pension fund against falling interest rates.

1. Initial Situation (Discount rate = 4%):

   • Present pension liability: 46 (grows to 100 in 20 years).

   • Hedging:

     • (I) Invest 46 in 20-year bonds.

     • (II) Enter an interest rate swap (fixed 4%, notional 46).

     • No cash remaining.

2. After Interest Rate Falls by 1% (to 3% discount rate):

   • Present value of liability increases to 55.

   • Bond value increases to 55.

   • The swap gains 9 (fixed received > floating paid).

   • Net result: The increase in liability is fully offset by asset and swap gains.

     
     

Key Insight:

Combining long-term bonds with interest rate swaps effectively hedges duration risk and cushions the impact of falling interest rates on pension liabilities.