The Impact of Rising Rates on Total Return Swap Hedges of Deferred Compensation Plan Liabilities
Benjamin Eisler, Managing Director, Atlas Financial Partners
In March of this year, SOFR increased from 0.05% to 0.30%. As rates may continue to rise, companies are evaluating the impact to Total Return Swap (TRS) hedges of Nonqualified Deferred Compensation Plan (DCP) liabilities.
Companies that are currently unhedged typically view the cost of their DCP as the annual return of the plan. If a $100 million plan grows by 6%, the cost to the company is $6 million. Hedging with a TRS converts this cost to SOFR plus a spread.
As a result, the TRS remains economical if the returns of the DCP exceed SOFR plus spread. SOFR would have to increase substantially for this to occur. Additionally, as SOFR increases, the returns of the fixed income portions of the DCP, and therefore the cost of the DCP, should increase as well.
Leaving a plan unhedged can also subject a company to significant earnings volatility.
Companies Using Physical Assets to Hedge
Companies that utilize physical assets to hedge – mutual funds or Corporate-Owned Life Insurance (COLI) – typically view the cost of their DCP to be their WACC. A TRS converts this cost from the WACC to SOFR plus a spread. Therefore, the TRS remains economical if the company’s WACC exceeds SOFR plus a spread. SOFR would have to increase substantially to exceed the WACCs of most companies.
Additionally, as SOFR increases, a company’s WACC will also likely increase. In addition to the economic benefit, the TRS provides tax and accounting benefits to companies using physical asset hedges as well.
Companies Using a TRS Overlay
Some companies utilize a TRS Overlay strategy, where they reallocate their physical asset hedge to a low-volatility strategy (fixed rate, fixed income, etc.), and then utilize a TRS to hedge the DCP. For these companies, the TRS will remain economical if the return of the low-volatility strategy exceeds SOFR plus a spread.
The chart below shows 1-month LIBOR and the Yield to Worst of the Bloomberg Agg over the last 30 years. The Agg is a good proxy for COLI fixed rate options, as these options credit very similar returns as the Agg (life insurance company general accounts are 90%+ investment grade fixed income).
The chart shows that there have been almost no periods where LIBOR exceeded the YTW of the Agg over this period. Additionally, on average, the YTW of the Agg has exceeded LIBOR by 1.75% since 1990. This TRS Overlay strategy would therefore have been extremely economical over the past 30 years.
We used LIBOR for the purpose of this analysis because SOFR is a relatively new rate with a short track record. SOFR is an overnight, risk-free rate – so it should also be lower than LIBOR.
This economic spread benefit is in addition to the accounting benefit of recording TRS gains and losses in the same line item as the plan expenses.
As rates rise, TRS hedges of DCP liabilities continue to provide economic, tax, and accounting benefits.