Dynamic Hedging Strategies for Cash Balance Pension Plans

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Date

2018-09

Authors

Zhu, Xiaobai
Hardy, Mary
Saunders, David

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Publisher

Cambridge University Press

Abstract

Cash balance pension plans with crediting rates linked to long bond yields are relatively common in the United States, but their liabilities are proving very challenging to hedge. In this paper, we consider dynamic hedge strategies using the one-factor and two-factor Hull White models, based on results for the liability valuation from Hardy et al. (2014). The strategies utilise simple hedge portfolios combining one or two zero-coupon bonds, and a money market account. We assess the effectiveness of the strategies by considering how accurately each one would have hedged a 5-year cash balance liability through the past 20 years, using real-world returns and crediting rates, and assuming parameters calibrated using the information available at the time. We show that there is considerable impact of model and parameter uncertainty, with additional, less severe impact from discrete hedging error and transactions costs. Despite this, the dynamic hedge strategies do manage to stabilize surplus substantially, even through the turbulence of the past two decades.

Description

This article has been published in a revised form in ASTIN Bulletin https://doi.org/10.1017/asb.2018.9. This version is free to view and download for private research and study only. Not for re-distribution, re-sale or use in derivative works. © Astin Bulletin 2018.

Keywords

cash balance pension, dynamic hedging, Hull-White model

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