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Bridge over ocean
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.