As a pension fund, we have an obligation to manage pension assets as best as possible. We have this obligation in order to be able to provide accrued pension benefits at all times. The assets in the pension fund must be large enough to meet our future liabilities.
The role of interest on our liabilities
We receive interest on our assets. The interest level and the average maturity affect the level of the required assets. The higher the interest rate, the less money we need now in cash to cover future pension payments. The lower the interest rate, the more money we need now in cash to cover future pension payments.
Risk for both high and low interest rates
A major risk for a pension fund is a drop in interest rates. For an investor it is the other way around. With a higher interest rate, an investor spends significantly more money on repayments. This results in less profit or even a loss.
How does an interest rate hedge work
In short, a pension fund wants to avoid lower interest rates, while an investor wants to avoid higher interest rates. Banks and/or insurance companies align these interests through interest rate derivatives, which create the interest rate hedge. When interest rates rise, the pension fund pays money to the counterparty (investors). When interest rates fall, the counterparty (investor) pays money to the pension fund. In this way, the risks of the pension fund (a lower interest rate) and the investor (a higher interest rate) are hedged.
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