CIO: Over 80%?
CIO: Can you offer advice on how you
determine your LDI hedging levels
Hunkeler: First of all, let me say that we
were early to the game, before we were late,
but I’ll get back to that later. We started
dipping our toe into the LDI waters back in
2002. At that time, we used derivatives to
extend the duration of our bond portfolio.
Then, in 2006, we decided to expand
CIO: How did you use date triggers?
that strategy to the entire plan, by putting
in place what today would be considered a
real glide path. The plan back in 2006 was
to gradually increase our interest rate hedge
relative to our liability to 50%. We planned to
use a combination of rate and date triggers to
get us to the desired level by the end of 2008.
At that time, we also determined that a 75%
hedge would probably be the right long-term
ending point for a number of reasons that
maybe are no longer applicable. We didn’t
dwell too much on the end point, because we
said, “Look, you’ve got to get to 50% to get
to 75%, so let’s just get started, and we’ll fine-
tune our planning when we get to that point
where fine-tuning makes more sense.”
So, my advice here would be not to get
too hung up on the end point, just get started.
Think about it like a moonshot. Just launch
the rocket and worry about steering it to the
moon when you get a little bit closer.
Hunkeler: In our original LDI plan, we
wanted to get to 50% by the end of 2008.
When we started in 2006, we assumed
that interest rates would be rising over the
foreseeable future, and if they did, it would
benefit us to get there gradually. But we also
decided if, by the end of each year, rates had
not reached certain target levels, then we
would go to our next hedge ratio regardless. So, it was either the rate trigger, or the
date trigger. Whichever one we crossed first
would be determinate of when we would go
to the next hedge level.
Originally, our hedging was done
entirely with swaps as an overlay to our under-
lying asset portfolio. Then, in 2008, during
the financial crisis, swap rates decoupled from
corporate bond rates, which led to this very
weird situation where our swaps were making
lots of money, while the spread on corporate
bonds was widening out.
We were concerned that when swaps
and corporates eventually recoupled, we
would lose all the money we had made on
our swaps’ position. So, at the end of 2008,
we decided to turn off the swaps overlay
The problem was, we didn’t find a good
reentry point for many years after that. It
wasn’t until 2016 that we actually reentered
the LDI glide path business, and now, we’re
probably somewhere in the middle of where
other large corporate plans are that are
doing LDI. That’s what I mean when I say
we were early before we were late.
CIO: How are you doing things differently, now that you’ve reentered?
Hunkeler: We have introduced date triggers again. Between 2008 and the present,
we reintroduced an LDI glide path, but we
did it without the date triggers. Instead, we
used a combination of funded status and
interest rate triggers. The problem was, we
never hit those triggers.
CIO: Are you fully hedged?
Hunkeler: No, we’re not fully hedged, and
I don’t think we would ever be fully hedged.
Again, a lot of this has to do with our forecasting and what we’re willing to tolerate in
terms of downside risk. From a philosophical
standpoint, there are only three ways we can
fill our funding gap: We can earn our way
out of it through better asset returns, we can
contribute our way out of it by putting money
into the plan, or we can wait for interest rates
to rise. At IP, we’re using a “three shovels”
approach. We aren’t going to rely on any one
shovel to solve our problem. We’re going to
use all three. One of the ways we’re doing this
in our LDI program is by making extensive
use of derivatives to get to the hedging ratios
we want to have. This enables us to maintain
a more growth-oriented asset portfolio while
still controlling our interest rate risk.
I’m actually somewhat surprised that
more plan sponsors aren’t using derivatives
to a greater degree to manage their interest
CIO: What advantage does it give you?
Hunkeler: The really great advantage is it
enables you to maintain a more growth-oriented asset portfolio, while still hedging the
interest rate risk through derivatives.
CIO: This year, you decided to make a
voluntary $1.25 billion pension contribution to be partially funded through
a $1 billion debt offering. How did you
decide on the $1.25 billion amount?
Hunkeler: Part of that had to do with what
we call the ‘regret factor.’ When we did
our pension contribution forecast with our
consultants at Rocaton, one of the things
we focused on was, “What’s the probability of having to make a contribution of at
least that amount over the next five and 10
years?” So, we looked for a number where
the probability of having regret—of having
put money into the plan and then later
realizing we didn’t need to put that much
money in—was quite low.
CIO: Is there something you’ve learned
during the process that people might
overlook? Anything that CIOs should
be especially aware of?
Hunkeler: First of all: The temptation
to bet on rates is huge. Don’t. The second
thing is: Don’t own this decision by yourself. This is a corporate-level decision that
needs to be made with, if not explicitly by,
senior management. And certainly, with
their direct input. Back before 2006, when
we were talking about going through an LDI
strategy, it seemed like a very scary decision, because we were talking about literally
billions of dollars of interest rate exposure.
We knew then, that this was a decision that
the company had to own, not just the investment office. So, that would be my second bit
of advice: get everyone involved.
Third, don’t be afraid to use derivatives to help hedge your interest rate risk.
This allows you to maintain a more aggressive asset portfolio while still managing the
interest rate risk. And finally, the key to
managing pension risk is developing a glide
path and then sticking with it. Try not to fall
off the path. —CIO
Read the extended interview at ai-cio.com.