The various stories about the catastrophic impact of rogue over-the-counter (OTC) trades are so well documented that listing them here would be redundant. However, there is a fast-growing recognition in the traditionally conservative world of pension management that appropriately designed and executed OTC derivatives – often re-branded as “structured products” or “capital market solutions” – can be among the more powerful and efficient risk control/ limitation tools available to the financial community.
The wide acceptance of exchange-traded options for currency overlays, asset transfers and basic short-term protection is being supplemented by a greater acceptance that OTC operations can also bring greater efficiency to the execution of asset management strategies. This is, in part, being helped by a greater level of understanding of the technology behind, and applications for, bespoke OTCs on the client side, in particular the actuarial profession. Their involvement in the wider use of exotic options packaged in tax- and regulatory capital-efficient wrappers to back guaranteed retail products has raised the profile of OTCs as a tool for this community.
Investment banks, as providers, have also taken steps towards a greater understanding of the issues facing the pension industry by employing pension professionals within their structured products teams. With the continued focus on pricing systems and risk control their ability to deliver OTCs that meet the demands of the pension sector has taken great strides.
In reacting to the needs of pension schemes, there has be a notable shift towards offering longer maturity products, for both fixed income and equity options, to match the longer end of the liability portfolio. There have been a number of significant trades in areas of the maturity spectrum previously almost completely illiquid. For instance, there is unprecedented activity in the 15-year into 15-year sterling swaption market; some banks will offer OTCs with even longer maturities.
OTC derivatives are now being given equal billing in some quarters, alongside reinsurance and classical asset allocation strategies, when considering the optimal asset liability management solution for a given situation. Indeed, the interface between these various techniques in the form of hybrid structures may often hold the key to a particular problem. This process has been accelerated enormously by the massive and sudden level of need caused by the relative collapse in long bond yields and the unexpected pace of change in mortality. Pension scheme managers are being forced to consider solutions that would previously have been unthinkable. There is nothing better able to draw the attention of a regulator than a scandal and the OTC derivative market has excelled at this in the past – although the UK personal pension industry has given it a close run over the past few years. The danger is that the infinitesimally small proportion of cases that have attracted adverse comment will detract from the capabilities and attributes of the vast majority of a given market.
German regulation was tightened significantly following the debacle of insurers taking leveraged bets, through options, on the forward yield curve without being able to value the trades enacted. The UK regulator clamped down on the use of geared ‘worst-of’ trades inside retail products. The theme that appears to be emerging is that regulators wish to eradicate the use of derivatives to skew economic returns but are ever more comfortable with their use as risk control tools.
Better definition, through guidance issued by regulators and new laws, of the status of particular OTC contracts in the context of matching or admissible assets has clarified the use of derivatives for asset liability management (ALM). Increasingly, the bespoke nature of such structures can provide a solution acceptable in both economic and regulatory terms.
The satisfaction of an ‘in connection with’ style test requires the exact matching of a given liability not only at expiration but also at every point throughout the term of the trade. The level of regulatory understanding by derivatives professionals allied to the greater sophistication in calibration techniques by actuaries makes achieving this much more likely.
The possibilities of using the capital markets to solve particular issues within the ALM field through OTCs are beginning to be explored in the continued hunt for stability, relative performance and efficient use of capital. Strategies based on plain vanilla fixed income or equity derivatives such as swaptions or puts are regularly employed to protect re-investment rates or to guard against sudden, untimely market re-adjustments. However, it is the exploration of such concepts as dual-asset hedging and the dynamic hedging of discretionary portfolios that is creating a more sophisticated range of products of direct relevance to pension schemes.
New techniques have thus evolved to deliver solutions as follows:
q weak with-profits funds. Maturing liability profiles allied to a low free-asset ratio place great pressure on management to alter asset allocation heavily in favour of bonds at a time when the potential for added growth through greater equity participation suggests the contrary. OTCs are used to provide equity participation but with a bond-shaped downside, enabling a scheme to optimise its growth potential while meeting the requirements placed upon it by the liability strain. Bespoke options of this form will enable the portfolio to prolong its greater level of equity holding through the purchase of an efficient array of derivatives contingent on the performance of both equities and bonds.
q guaranteed annuities, which dominate thinking in the UK, can be mitigated through the use of tailored swaptions that offer a significant advantage over reinsurance. A simplistic view of reinsurance is that it eases immediate solvency pressure through cash-flow and some risk transfer. OTCs can remove the risk from the scheme with no contingent retention of contingent liability.
q the requirement under certain regulatory regimes, such as that of Denmark, to provide for a certain guaranteed yield level in the face of punitive tax charges for holding equities can also be effectively catered for through the use of dual-underlying instruments.
q re-investment rates within a portfolio can potentially be enhanced through the ability to add the out-performance potential of equities over bonds, as reflected in the high levels of volatility. This can be achieved through the use of a swaption programme whose strike is linked to equity performance on a contingent basis.
q the hedging of specific liability profiles, such as that created by the pension mis-selling issue in the UK, is firmly within the capability of current OTC technology. Dual-underlying options potentially offer solutions in any situation where the liability has a bond-dominated aspect but the assets are wholly, or in part, equity-based. This would also extend to those territories that are very low users of equity due to liability considerations, but would like to access some degree of equity’s upside potential.
The technology that enables banks to dynamically hedge discretionary funds is also an important component of such structures. Not only does it remove the basis risk, thus creating a closer match, but also enables the writing of equity options over longer maturities than is the case with options on indices. This is achieved with a minimal level of impact on the discretion of the fund manager when structured with some fairly simple internal mechanisms.
Without rehearsing the arguments that support, or otherwise, the shift from defined benefit (DB) to defined contribution (DC) provision, the impact on the pensioner is a shift of risk from the scheme or scheme sponsor to the individual. Structured OTCs can offer some very neat solutions to this conundrum. Whilst retaining the DC attribute of a known liability profile on the part of the sponsor, a structured OTC can deliver a DB style of risk to the pensioner.
Strong equity participation with protection against untimely devaluation can be provided through a put strategy linked to an equity fund. Meanwhile, the effects of extreme shifts in bond yields are neutralised through a contingent link to swaption levels. This will remove much of the enormous readjustment in retirement income resulting from relatively small shifts in bond yields whilst allowing diversification into other growth assets.
The flaws in most lifestyle funds, where the transfer between equity and bonds takes little or no account of market conditions, can also be resolved using such technology. The fashion for post-retirement investment in a diversified portfolio can also have its risk profile substantially altered.
Ultimately, the new breed of OTC, tailored to match the exacting requirements of the pension sector, allied to the banks’ internal improvements in trading systems and risk control, will establish structured derivatives as a credible alternative to other financial instruments.
Who knows, perhaps exotic OTCs, thanks to their chameleon-like ability to match different asset/liability portfolios with various regulatory and tax conditions, will prove to be the keys to unlocking the true pan-European pension scheme.
John Godden is head of structured insurance products at Paribas in London