Price Perspective - In Depth

Vol. 6 - Hedging a Cash Balance

Justin Harvey, CFA, ASA, Solutions Strategist for Multi-Asset Solutions

Executive Summary

  • Recent improvements in the funded status of many corporate defined benefit plans have accelerated interest in liability-driven investing (LDI) and led many sponsors to more clearly articulate their LDI objectives. However, the fixed income benchmarks typically used to measure the performance of LDI strategies can be improved.
  • T. Rowe Price has developed a methodology for constructing custom LDI benchmarks at the most granular level—from the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set.
  • Due to the benefit formula mechanics of many cash balance plans, a unique solution customized to each specific plan is required to ensure that LDI benchmarks accurately reflect the interest rate exposures embedded in each cash balance plan’s liability.
  • To highlight the potential benefits of T. Rowe Price’s LDI customization process, we have created a benchmark for a hypothetical cash balance plan with the following characteristics:
  1. Half of the liability is associated with the cash balance design and half is derived from the legacy final average pay plan that existed prior to cash balance conversion (Figure 1).
  2. Cash balance benefits are payable as lump sums.
  3. Participants’ notional account balances receive an annual interest credit based on the 30-year Treasury yield, with a minimum of 3.50%.

As corporate defined benefit plans increasingly have shifted their focus to portfolio de-risking, many have sought fixed income benchmarks that are better aligned with the specific objectives they hope to achieve through liability-driven investing (LDI). Some sponsors have shifted to longer-duration measures, such as the Barclays Long Credit Index or Barclays Long Government/Credit Index, while others have adopted compound benchmarks or duration-targeted indexes. 

T. Rowe Price believes an even higher level of customization is both necessary and feasible. Accordingly, we have developed a methodology for constructing custom fixed income benchmarks at the most granular level possible—the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set.

Based on the bonds in the relevant opportunity set, we create a benchmark that matches, as precisely as possible, a plan’s projected liability cash flows. To ensure continuous liability matching, this investable benchmark is then reset each year to reflect the plan’s actuarial experience, new pension cash flow accruals, and bond market developments.1


The first step in our approach for cash balance plans is to segregate the projected cash flows for each benefit structure and develop separate benchmarks for each. This is necessary because final average pay and cash balance cash flows have different interest rate exposures. The two benchmarks would then get weighted based on the amount of liability associated with each benefit design to form a single benchmark for the total liability replication.

In this example, we assume the sponsor is focused on accounting results and so we use AA rated bonds in the benchmark construction. The value of the final average pay cash flows will depend on movements in both the underlying Treasury rates and the credit spread between Treasuries and AA bonds. We use our cash flow optimizer to create an investable benchmark for just the liabilities stemming from the legacy final average pay plan (Figure 2a).

We use a similar approach for the separate cash balance cash flows (Figure 2b), but there are three nuances that make the process different than for the final average pay cash flows:

  1. The expected cash flows are less stable year over year, reflecting the fact that lump-sum payments can fluctuate significantly based on actuarial experience. Impact: It is more important to match duration, convexity, and yield than the cash flows for the cash balance plan, so our optimizer penalties are adjusted accordingly.
  2. The cash flows are already indexed to Treasury rates since the interest credit for participant account balances is based on the yield on the 30-year Treasury bond. Impact: The benchmark should have the same spread duration as the cash flows, but all of the Treasury duration should be hedged out of the benchmark by including short positions using derivatives such as Treasury futures or interest rate swaps.
  3. The plan has a minimum interest rate that could affect the duration calculation depending on the relative relationship between the minimum crediting rate and the current market rate. Impact: The notional value of the derivatives should change based on the market environment. If the current 30-year Treasury yield is below the minimum interest crediting rate, then the cash balance liability will have full exposure to changes in Treasury rates and the short derivative positions will not be necessary in the benchmark. On the other hand, if the current 30-year Treasury yield is above the minimum rate, the short derivative positions should be included in the benchmark to reflect the notion that the cash flows are already indexed to Treasury rates.

The result of the process is a cash bond benchmark that matches cash flows, duration, spread duration, and yield, with offsetting positions in Treasury-based derivatives for the cash balance plan. The benchmarks, optimized separately, would then be combined into a single benchmark for the overall plan (Figure 3 and Figure 4).


Plan Cash Flows for a Hypothetical Cash Balance Plan IncludingBoth Average Final Pay and Cash Balance Liabilities

As of 30 Sept 2015

Source: T. Rowe Price.



Hypothetical Custom Benchmark (AA Credit Universe) For Final Average Pay Component of Plan Liability

As of 30 Sept 2015

Sources: Barclays, T. Rowe Price; data analysis by T. Rowe Price.



Hypothetical Custom Benchmark (AA Credit Universe) For Cash Balance Component of Plan Liability

Data as of 30 Sept 2015

Sources: Barclays, T. Rowe Price; data analysis by T. Rowe Price.



Top 10 Issues in Hypothetical Custom Cash Balance Benchmarks

As of 30 Sept 2015

Final Average Pay Component for Liability Weight
IBM 5.88 '35 1.59
Walmart 5.25 '35 1.59
Quebec 7.50 '29 1.44
Connecticut 5.85 '32 1.37
Statoil 7.15 '29 1.31
Ohio 3.99 '29 1.30
Shell 6.38 '38 1.27
Oregon 5.99 '27 1.24
Massachusetts 4.91 '29 1.19
Walmart 6.50 '37 1.18
Cash Balance Component of Liability Weight
IBM 5.88 '32 2.35%
Statoil 7.15 '29 2.20
Oregon 5.89 '27 2.18
Ohio 3.99 '29 2.18
Connecticut 5.85 '32 2.10
Massachusetts 4.91 '29 2.00
Walmart 5.88 '27 1.89
Korea Export-Import Bank 3.25 '26 1.80
Quebec 7.50 '29 1.75
IBM 7.00 '25 1.39

Source: T. Rowe Price.


Appendix: Constructing Custom LDI Benchmarks

T. Rowe Price has developed its own custom LDI benchmark methodology, which we believe has the potential to:


  • reduce liability tracking error compared with market cap-weighted benchmarks and composites,
  • allow managers to tailor their investment process more closely to sponsor objectives in terms of spread, duration, and curve sensitivities,
  • demonstrate their performance relative to plan liabilities more precisely.



Hedging asset performance should be monitored as closely as possible against the liability measurement most meaningful to the sponsor. Because different regulatory and accounting regimes use different discount rates, the optimal opportunity set will depend on the sponsor’s de-risking priorities.


Once the relevant fixed income opportunity set has been defined, bonds are broken down into their discrete copon and maturity cash flows. In essence, this procedure treats every cash flow as if it were a separate zero-coupon bond, then uses those flows to construct a zero-coupon yield curve that can be matched against the plan’s cash flows.


Discounting plan cash flows using the model curve provides the yields needed to determine the plan’s interest rate sensitivity at each point on the curve. The curve is stressed by incrementally increasing and decreasing the yields at each point in order to determine key rate durations (KRD).


Asset cash flows are matched to liability KRDs, taking into account how much impact each point on the curve has on the overall present value of plan liabilities. The result is a customized benchmark in which asset and liability weights are matched relatively precisely, especially in the most interest rate sensitive portion of the curve.

With the structure in place, the mandate to the asset manager becomes relatively straightforward: either replicate or outperform the liability-matching cash flow benchmark, while also matching spread and curve sensitivities as closely as possible using instruments that are actively traded and have a reasonable degree of market liquidity.

Important Information

This material is directed at institutional investors only and has been prepared by T. Rowe Price Associates, Inc. for informational purposes. This information is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of August 2014 and are subject to change without notice.

The information presented has been developed internally and/or obtained from sources believed to be reliable; however, T. Rowe Price does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained herein may no longer be true after the date indicated . Any forward-looking statements speak only as of the date indicated and T. Rowe Price assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements.

Each of the hypothetical plan(s) and custom benchmark(s)/sample strategy presented reflects a model and is not indicative of an actual plan or benchmark or attendant characteristics. The hypothetical plan is representative of an annuity based defined benefit pension plan. The hypothetical custom benchmark(s)/sample strategy is based on the applicable bond universe for the relevant liability measure. Certain of the assumptions have been made for modelling purposes and are unlikely to be realized. The hypothetical plan, and thus the custom benchmark as well, have been created for modelling purposes with the benefit of hindsight. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in creating the hypothetical plan and custom benchmark have been stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented. The construction of the plan and benchmark in this manner has certain inherent limitations and may not reflect the impact that material economic and market factors may have had on the custom benchmark construction if an actual plan had existed during the time period presented. Actual tracking of T. Rowe Price’s custom benchmark of any particular plan, including (among other things) yield, annualized return, liability-relative tracking error and average monthly return may differ substantially from the hypothetical scenario presented herein.

The specific issues referenced herein should not be viewed as recommendations and it should not be assumed that any investment in the securities identified was, will or would be profitable.

The information presented is supplemental information for GIPS purposes; however, because T. Rowe Price does not currently manage any accounts the strategy presented, a GIPS-compliant presentation is not available. A complete list and description of the firm’s composites is available upon request.

This document, including any statements, information, data, and content contained therein, and any materials, information, images, links, sounds, graphics, or video provided in conjunction with this document (collectively, “Materials”) are being furnished by T. Rowe Price for your general informational purposes only.



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T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. T. Rowe Price has been independently verified for the twenty four-year period ended June 30, 2020, by KPMG LLP. The verification report is available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance on the accuracy of any specific performance report.

TRP is a U.S. investment management firm with various investment advisers registered with the U.S. Securities and Exchange Commission, the U.K. Financial Conduct Authority, and other regulatory bodies in various countries and holds itself out as such to potential clients for GIPS purposes. TRP further defines itself under GIPS as a discretionary investment manager providing services primarily to institutional clients with regard to various mandates, which include U.S, international, and global strategies but excluding the services of the Private Asset Management group.

A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

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