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27 February 2018 Financial Analysts Journal

Mind the Gap: Using Derivatives Overlays to Hedge Pension Duration

  1. James F. Adams, PhD, CFA
  2. Donald J. Smith, PhD

Recent legislation and accounting rule changes motivate defined-benefit pension plans to manage the interest rate risk arising from volatility in their liabilities, as measured by either the accumulated benefit obligation (ABO) or the projected benefit obligation (PBO). For either measure, asset portfolios comprising equity and fixed-income bonds usually have much lower average durations than do liabilities. This article discusses how interest rate derivatives overlay strategies can be used to reduce or eliminate the negative duration gap. A theoretical model is developed to show how to calculate the ABO and PBO measures and their duration statistics.

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