A powerful tool, but use with care
Derivatives are now widely recognised as a tool that pension schemes can use to manage their overall risk exposure. There remains a common perception, however, that derivatives are speculative products and extremely risky. In practice, pension schemes are interested in derivatives primarily for their hedging capabilities, using them to reduce risk exposures rather than to increase them.
The correct use of derivatives places a powerful tool in the hands of trustees and investment managers, giving them flexibility in managing their funds. For a number of larger pension schemes the use of derivatives is standard practice, and they are long past the stage of debating the pros and cons. But for the majority of pension schemes exposure is through managers seeking to invest assets more efficiently.
Derivatives do require special, and almost certainly dedicated, management, both to manage and to service the margin calls – the daily payments that will be required to the clearing house for futures and options contracts. Clearing house trades must be distinguished from over-the-counter (OTC) trades, in which a considerable counterparty risk exists between buyers and sellers
Some of the main applications of derivatives for pension funds are:
q providing securities exposure for cash balances;
q anticipatory hedging – for example, protection against downside market movements;
q providing market exposure during the transfer of assets (by cash) following a merger or acquisition;
q efficient portfolio management, by facilitating asset allocation and portfolio reorganisation;
q portfolio protection, and
q currency hedging.
Indications are that volumes for pension schemes are not great in total. Investment firms see the potential to increase business, but are not yet pursuing this as actively as they might.
There are no regulatory issues in using derivatives for UK schemes, and the Inland Revenue does not in most cases assess their use for income or capital gains tax purposes. The situation in other European states varies from market to market. Tax treatment may vary, but will typically mirror the status of the pension scheme in question. In some major markets there is a low level of private pensions provision and therefore a limited market for derivatives. Also, some European countries with a significant level of private provision already have low-risk investment strategies based on bonds, and therefore there is a much lower potential demand for derivatives to offset risks.
The pension scheme’s trustees must ensure their trust deed and rules give them the power to use derivatives. It is also necessary to ensure that there are adequate powers and instructions given to the appointed investment manager, and thought will also have to be given to any special reporting and controls that might be needed.
The use of derivatives may complicate the normal process of measuring performance, which is usually asset-based. This will have to be discussed with the performance reporting service. Trustees will need some means of judging the effectiveness of their derivative strategies.
Although the basic products and techniques are well established, considerable effort is being invested in developing new applications. One problem area being looked at in the UK is the minimum funding requirement (MFR). Schemes are subjected to an essentially short-term MFR test that would suggest generally a greater emphasis on bonds. In this context funds are seeking some kind of hedge for the implied volatility of their real asset strategies. Derivatives offer a means for this.
Investment banks give the impression that all things are possible, and that they can write whatever the client wants. I have been told, for example, that “we can make an equity look like a bond”. Some pension fund trustees might ask why anyone would want to do that. But something that could deliver a bond yield with the capital growth of an equity would be quite a product!
There is clearly plenty of scope for derivative deals, as long as everyone understands what they are doing and adequate controls are in place. This seems to be a perfectly logical development in an investment strategy. The products and the technology are at present well ahead of the pension fund trustee decision process, but this will change.
There are no regulatory or tax barriers to using derivatives, but as already stated there may be a need to gain the necessary investment powers. A major barrier is still probably ignorance of these products. A second barrier is related to administration, and the ability of investment managers and trustees to administer such contracts.
No strategy is without its risks, and that includes derivative strategies. Investors need to be clear as to what they are trying to achieve, and have the derivative strategies properly explained. In using derivatives to control risk, they need to understand the specific issues involved.
With derivatives, are there risks connected with the counterparty defaulting? Futures traded in London, for example, are cleared by the London Clearing House which acts as counterparty to every transaction. To insure against this guarantee, should the original counterparty default, the LCH calls sureties from those holding derivative contracts. These are both initial margin calls and variation margins that are meant to cover daily payments of losses incurred, although a major movement in the market in a single day might expose the existing collateral level.
There is almost infinite capacity in the market to write contracts, and the pension funds have hardly started yet. There is a significant challenge here to the way funds are managed.
Paul Haines is director, PricewaterhouseCoopers in London