Working smarter with derivatives: More pension funds are laying off unwanted risk using these instruments

Derivatives can be used to improve the return profile of pension funds' active risks, as outlined in this article by Watson Wyatt.

Many pension funds are starting to like the idea of derivatives. In the past, some saw these strategies as too complicated, too dangerous, or simply as offering no financial advantages. But as funds and their sponsors search for more effective ways to manage risk, they are realizing that derivatives can alter the nature of that risk in ways that are not possible in the cash markets.

Pension funds are exposed to many risks, some of which they take actively while others they may be taking passively. Funds actively take equity and credit risk, for example, because they feel they are being adequately rewarded. Passive risks include movements in the present value of their liabilities due to changes in interest and inflation rates. Many funds do not believe they are being adequately compensated for these risks. The importance of derivatives is that they can be used to improve the return profile of their active risks, and to neutralize unwanted passive risks.

Neutralizing passive risks

These passive risks are usually created by a mismatch between a fund's assets and its liabilities. A pension fund can use interest rate swaps, for example, to remove the risk that a change in interest rates will have an impact on its funding level. Or it can enter into an inflation-linked swap so that it is no longer exposed to changes in the experienced rate of inflation. The up front costs of neutralizing these risks can be low.

But as with any investment strategy, there is a downside as well as an upside. A pension fund that enters into an interest rate swap is no longer vulnerable to a fall in interest rates - but neither will it benefit from a rise. Similarly, if a fund uses inflation swaps to protect itself against a rise in inflation it will no longer benefit from a fall.

Another passive risk pension funds face is that of corporate sponsor default. An interesting possibility for some funds would be to neutralize this risk by buying protection for any funding deficit in the Credit Default Swap market. This strategy would entail paying an annual premium to a counterparty, and receiving a pre-agreed sum of money that would cover the deficit if the sponsor defaulted. The size of the premium would depend on the credit quality of the sponsor.

Improving risk return profiles

The uses of derivatives in pension portfolios are growing all the time as they become more accepted, and as the markets themselves expand. As well as neutralizing risk, derivatives can make risk-taking more efficient.

One application is to diversify fixed-income exposure. A fund looking to invest in highly-rated long-dated corporate bonds in its domestic currency - sterling, say - may find a limited number of these credits available. Investing in this limited universe of credits creates overexposure to specific issuers, industries or countries which fixed- income investors are not compensated for. One solution is to buy foreign- denominated bonds in order to gain exposure to a more diversified pool of issuers, and then use currency swaps to turn these cash flows back into the domestic currency. The resulting portfolio will look like a domestic bond portfolio, but with exposure to a diversified range of credits.

Pension funds can also use the growing credit default swap (CDS) market to increase efficiency in their bond portfolios. Put simply, they can sell protection to other corporate bond holders, and take on the credit risk in those bonds, in exchange for a regular premium. In this way they gain exposure to the creditworthiness of the bond issuer without being exposed to currency and interest rate risk, as they would if they bought the bond itself. So the CDS market allows investors to gain diversified exposure to a large pool of international bond issuers.

Another use of derivatives among pension funds is to sell unwanted equity return. This may seem counter-intuitive, particularly at present, but this is how it works. Pension funds take equity risk because they expect equities to outperform bonds (bonds are a proxy for their liabilities). This bet is sometimes inefficient, because there is a certain level of outperformance above which the pension plan will be more than fully funded. In this case, it might be more efficient to sell this possible excess outperformance against bonds to generate a premium. This is done by selling outperformance call options, which are based on the outperformance of equities relative to bonds. The premium, which is effectively added income for the fund, can be used to buy more assets or else to buy protection against the fund's equity investments underperforming bonds.

Creating investments synthetically

Pension funds can use derivatives strategies to create an investment exposure that would not be possible with physical securities. For instance, funds would love to see a large, liquid market in inflation-linked corporate bonds to match their inflation-linked liabilities and give them an enhanced return over index-linked government bonds. Such a market unfortunately does not exist. But an index-linked corporate bond portfolio can be created synthetically. The fund buys conventional corporate bonds that generate fixed coupons and principal payments. It then enters into an inflation swap in order to turn these fixed cashflows into inflation-linked cashflows. The result is a corporate bond portfolio generating inflation-linked cashflows.

Handle with care

So far, pension funds have been most enthusiastic about using inflation swaps and outperformance options. To enter into these arrangements they typically deal directly with a bank under standardised legal agreements known as ISDAs. Other derivative strategies, such as the use of credit default swaps to gain diversified corporate credit exposure, are usually managed by a fund's asset manager.

There are some derivative strategies offered to pension funds that we have generally found trustees to be less enthusiastic about. Structured credit arrangements such as CDOs (collateralized debt obligations) are very complex and can be quite opaque. Pension funds will have to put in a lot of time and effort to understand the risks and returns of these structures. Funds should be aware that the risks of a CDO are not the same as that of a corporate bond with the same credit rating.

Some bonds that offer enhanced yields need to be treated with caution. They can change the interest rate risk profile of a portfolio, and may cause pension funds unknowingly to double up on their exposure to a fall in long-term interest rates. In general, there are potential problems with any structured product that includes options or optionality, because the risk/return payoffs are asymmetric and they may react in unexpected ways to changing economic conditions. These products need to be thoroughly understood and, we would suggest, stress tested so that all parties understand the inherent risks.

A final word of caution - derivatives carry a degree of operational risk. An investment manager may be keen to use swaps and options to generate outperformance for his client. But over-the-counter derivative instruments are far more complex to trade and maintain than cash securities, and pension funds should make sure that their manager's back office people and systems are up to this challenge. There is also an onus on the trustees to ensure that the costs implicit within any derivative strategy are reasonable.

To sum up, derivatives can be wonderful tools for pension funds when they are used properly. They can provide protection, enhance performance, and help match assets with liabilities. But funds do need to make sure that no unpleasant surprises lurk within the strategies or instruments they are considering.

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