Despite the number of providers willing and able to help European pension funds implement derivative-based strategies in dealing with runaway liabilities, as yet, many are steering clear of structured products altogether.
Jan Longeval, director at Degroof Institutional AM (DiAM) in Brussels, agrees with others that there is unwillingness among pension funds to use these often complex derivative-based products.
“From our side, it will be increasing in the future (provision of structured products), but generally speaking there is a high degree of reluctance for using structured products,” he says. This is because trustees do not always understand them.
“Quite often they don’t have a sufficient technical command of the products,” he says. However, among DiAM’s clients, most already allow some use of them.
Longeval says that two thirds of the firm’s mandates authorise the use of structured products up to a certain percentage of the portfolio. And there are quite a few products which come into this category that are used as a matter of course by many institutional investors, such as convertible bonds.
“The biggest advantage you can have with structured products is you can achieve a risk/reward profile which is unattainable with standard products,” says Longeval.
More information is needed about the area, he says. The first port of call for pension funds interested in making use of structured products should be their investment manager, as long as their knowledge is sufficient.
”It is quite technical,” he says. “You need people who really understand what they’re dealing with. If you’re using someone who doesn’t have a good understanding, then it can become dangerous.”
But there will inevitably be more use of them in the future. Pension funds will increasingly turn to them, reverting to swaps to deal with their overall long-term liability, he says. They will be using long-dated bonds or all swaps to increase duration to 30, 40 or even 50 years.
This is particularly the case in the Netherlands where the new financial assessment framework (nFTK) rules make it a near obligation to do so. “But quite generally, people have become much more aware of their liabilities,” he says.
Aware of the shortage of long bonds in the market, many asset managers have come up with their own solutions for pension fund clients seeking to increase duration. In the Netherlands, NIB Capital says zero-coupon bonds are good instruments for stabilising the pension cover ratio when market valuation is introduced for liabilities, and increasing the duration of assets. It can provide the Pension Bond 2025, which has a maturity of 21 years.
Derivative-based products take many different forms. Merrill Lynch Investment Managers (MLIM), for example, has recently launched three new fixed income funds which generate alpha. The new funds are part of MLIM’s liability solutions product range, the firm says, which was launched in 2003 and has already attracted more than £4bn (e5.7bn) in assets.
The three funds are high performance over five years index linked gilt fund, high performance over 15 years gilt fund and high performance cash fund. They all seek to generate higher returns for pension, insurance and charity clients, and are offered via a Jersey-based pooled umbrella vehicle. The target is benchmark plus 2% gross of fees.
MLIM says dynamic management of the active positions of the funds will be a critical factor in driving performance. “The team will use derivatives, such as futures and swaps, which allow market exposure to be switched in a speedy and cost effective manner, enabling efficient position management,” it says.
One indication of the growing use of derivatives to lengthen maturity is activity in the swaps market itself. Joseph Moody, principal of fixed income at State Street Global Advisors (SSGA) says liquidity in Europe is definitely growing, although of course activity on the swaps market is linked to other things besides pension fund use.
Different countries have different requirements, Moody notes. For example, interest rate swaps are particularly used for hedging their interest rate and duration risks. Inflation swaps are not quite the market in Europe as they are in the UK.
“Most pension funds realise that falling interest rates are impacting on their liabilities,” he says. The answer lies in the resulting discrepancy between the treatment of liabilities and prevailing interest rates. “If you’re discounting your liabilities by 5% and interest rates are 4%… assets have got to go up by the same amount, if not more.” The effect of the 20% discrepancy on the deficit will be to increase it by more than 20%.
“If you’re underfunded and you are still exposed to this risk, then it becomes even more severe,” says Moody.
Pension funds are being forced to consider liabilities more carefully because they are being marked to market. This has made the financial regulators more comfortable with pension funds using swaps. As a result of the new FRS17 accounting standards which are being imposed on companies, corporate balance sheets have to indicate how big the deficit at the pension fund actually is.
In the case of some companies, the pension fund can be larger than the value of the sponsor’s business, which indicates the gravity and urgency of the situation.
“How do you use financial products to solve that problem?” asks Moody. “With bonds, perhaps, but the answer is that they don’t remove the risk. So the only way around that is a more tailored, structured solution.”
Zero-coupon bonds, where the yield is effectively paid in future years, can be an answer for medium and smaller funds, he says. SSGA has brought out a pooled solution, he said, and a packaged intermediary solution.
SSGA also has a product called Pooled Asset Liability Matching
Solution (PALM) for pension funds that want to move closer to their
SSGA counters reluctance on the part of pension funds to use derivatives by showing them the alternatives. “We demonstrate how much risk they’re running, and then we show how much the risk will change if they invest in a derivative asset liability solution.
“The difference is very significant. Derivatives are perceived to be high risk for pension funds because they hear about how they can be misused,” he says.
Once people realise that this type of product is here to help them, rather than increasing their risk, they will become more popular, Moody believes.