No need to shy away
European pension funds are not the most prolific users of derivatives. However, for some, options, futures and swaps form an integral part of the asset management process. This article provides a broad overview of the use of derivative instruments in several European markets and, more importantly, how these instruments can be employed to improve the management of a pension fund.
We distinguish between liability and asset-driven strategies that can be employed by pension funds. Liability-driven strategies can improve the asset-liability management of the pension fund, a basic example being currency hedging. The pension fund’s liabilities are denoted in domestic currency, but it may hold non-domestic bonds and is consequently exposed to exchange rate movements. This risk can be eliminated (and the asset-liability match improved) by selling foreign currency forwards.
Asset-driven strategies, on the other hand, are employed purely to enhance the asset management process and are not connected to the underlying liabilities. An example here is the use of futures for tactical asset allocation (TAA) – short-horizon changes in the broad asset allocation to add value over the strategic benchmark or for equitising cash. The latter involves providing a futures overlay for any cash held, so that this will in effect earn an equity rather than a cash return.
The prevalence of derivatives varies across Europe because of differences in market structures and regulatory regimes. In the UK, the largest pensions market in Europe, the use of derivatives is not restricted by regulations. However, those funds without appropriate Investment Management Regulatory Organisation registration (externally managed ones) are not allowed to take derivatives positions directly. Many of these funds do give discretion to their managers; however, the use is still limited.
Similarly, in the Netherlands, the use of derivatives by pension funds is not restricted. Many funds use futures and currency forwards and some of the larger in-house managed funds employ a range of instruments to implement their investment strategy. For example, they implement futures and options to obtain exposure to commodities and to manage the duration and credit exposure of their bond portfolios.
Large funds in Sweden are subject to few restrictions and use some derivatives for currency hedging and TAA. The Danish system also allows sufficient flexibility to use derivatives.
In Germany, pension funds in the form of Pensionskassen are regulated by the Insurance Supervisory Authority (BAV) and are subject to the same quantitative and qualitative investment restrictions as insurance companies. The restrictions also apply to the use of derivatives, forwards and structured products and are clarified in separate circulars. These allow derivatives, including forwards, to be used for hedging and portfolio insurance, gaining advance exposure to an underlying and return enhancement.
The general rule is that derivatives may not be used for arbitrage or speculative purposes where there is no long position or no intention of holding a long position in the underlying. Whilst hedging strategies can be employed on 100% of the portfolio, quantitative retrictions apply to the other two areas above. For example, return enhancement strategies are limited to 7.5% of the value of the portfolio and the purchase of call options whose premium is higher than 115% of the price of the underlying is disallowed altogether.
By contrast with Germany, Swiss pension funds are subject to few restrictions and seem to make liberal use of their freedom. Of course, this applies mainly to the larger funds, which have extensive in-house trading capabilities. Anecdotal evidence seems to suggest that Swiss pension funds use derivatives mainly as tools for return enhancement rather than in an asset-liability context.
There are several reasons why pension funds might consider derivatives. Firstly, they provide implementation flexibility. It is often easier and more cost efficient to obtain exposure through derivative markets than trading in the underlying securities. It is, for example, easier to reduce equity exposure through the futures or swap market, rather than selling individual equities. Besides that, some derivatives, such as options, provide asymmetric pay-offs. By buying put options on an equity portfolio, funds are protected against the negative impact of downturns in the equity markets, but still participate in the upside gains.
Furthermore, derivatives make it possible to obtain exposures that are difficult to access via the underlying. An example is commodities, where entering swap and futures contracts is the most efficient way to invest. It is practically impossible to trade the underlying physicals without incurring substantial costs.
These are all compelling reasons to use derivatives, but still the use is not widespread among pension funds.
In the remainder of this piece we show how derivatives can be used to reduce risk and to ‘shape’ exposure, rather than take speculative bets.
As mentioned earlier, derivatives can be very useful for managing pension funds’ asset-liability risk. We discuss a few examples here:
q Guaranteed products In Germany, investment return is particularly important in the current low interest rate environment. As contribution rates are relatively inflexible, investment return is the balancing item in the following equation:
Pension fund contribution + investment return = members’ (largely) guaranteed
Although the rate of interest used to calculate the contribution is set relatively conservatively, the contribution rate for a member over his/her whole career is usually guaranteed at the date of joining the plan. This means that the pension fund is subject to investment risk on the future contributions. Clearly, it makes sense to use derivatives such as interest rate swaps, swaptions or structured products that provide both a guaranteed minimum return and exposure to equity upside.
q Inflation swaps In many cases pension payments are linked to inflation. As inflation increases, funds have to increase benefit payments by more than they had expected. Inflation swaps can reduce this risk. Under such an arrangement the fund pays part of its investment income to a counter-party through an over-the-counter transaction usually intermediated by a bank. In return, it receives a payment that is linked to inflation.
A typical structure would include the fund paying a short-term interest rate (eg, Libor or Euribor) to the counterparty and receiving the current inflation rate plus, say, 3%. This reduces the fund’s inflation risk, because when inflation goes up, both the benefit payments and the income on the swap rise.
Inflation swaps are very appealing to pension funds, although the main issue with these is liquidity; it is not always easy to find a counterparty that is willing to pay inflation.
q Outperformance options These are slightly more involved and linked to the way pension assets and liabilities are valued.
Increasingly, pension liabilities are calculated using bond yields. This means that liability values fluctuate as bond markets move. Moreover, the new UK accounting standard for retirement benefits, FRS 17, also prescribes that changes in a pension fund’s surplus or deficit should be recognised immediately in the balance sheet of the sponsoring company. With UK pension funds heavily invested in equities, this means that moves in the level of the equity market relative to the bond market immediately feed through to the company balance sheet.
The table shows the asset and liability profile for a sample pension fund with an equity allocation of 75% (in line with the average UK pension fund). As liabilities are valued using bond yields, the ‘allocation’ of liabilities is 100% bonds. If equities stay flat, but bonds rally by 10%, the pension plan’s funding position deteriorates by 7.5% (75% of 10%).
It is possible to obtain protection against this risk, by buying an outperformance option. The payout of this option is linked to the performance of one asset (in this case equities) to another (in this case bonds). In the above example, an equity-bond outperformance option would pay out 7.5% and would offset the deterioration in the funding level described above.
We stress that this is not a standard equity option, because its payout is based on the relative performance of equities versus bonds, rather than the absolute equity return.
Other applications of derivatives for pension funds include:
q Default swaps These are swaps whereby pension funds can receive a spread over the prevailing interest rate, but have to pay when a default occurs on a particular corporate name, or in a basket of names. An example is where the fund would pay the current interest rate and receive the interest rate plus, say, 150 basis points (thus net receiving 150 bps). If a default occurs in a basket of identified names, the receiving flow on all or part of the basket would be set to zero, so that the pension fund would end up paying the prevailing interest rate.
These structures are interesting in that they generate some yield pick-up in the current environment of low interest rates.
q Transition management Index futures and other strategies can be employed in transition management, ie, the process of transitioning portfolios in the course of a change of manager or a change in asset allocation. Derivatives can be used to gain or scale down exposure to a portfolio more quickly, thus reducing tracking error between the buy and the sell portfolios.
Although many pension funds have tended to shy away from the use of derivatives, we have illustrated that they can, indeed, be a useful tool in implementing strategies that may actually reduce rather than increase risk.
Jeroen van Bezooyen and Sabine Mahnert are associates with the European
Pensions Group at Morgan Stanley