The pensions industry is still waking up to dangers of letting future liabilities outpace assets. The growing realisation that more must be done to meet future obligations has given rise to an increasing number of derivative-based products which, their creators say, can help bridge the gap.
With the careful use of derivative instruments, structured products can both produce returns which safely match the profile of liabilities, as well as generating much needed added returns to swell asset levels following their post-market dip depletion.
In a recent pensions conference hosted by AXA Investment Managers, Juan Yermo from the OECD working party on private pensions, saw guaranteed products playing a significant role in the future.
Discussing pensions policy and regulatory reform, he looked at the challenges facing public and private pension schemes and the implications for the savings and financial markets.
In discussing whether these trends would speed up the transformation of pension arrangements based on collective risk sharing and income redistribution, he concluded that products with guarantees have a bright future, notably in countries where defined contribution plans form the core of statutory pension systems.
Ravi Rastogi, principal at consultancy PSolve Asset Solutions in London, says, in the UK at least, there are more pension schemes now using structured solutions than before. But it is not so much the fact they are using structured products that is new, rather that schemes are now being more deliberate in their approach to the use of instruments represented by this type of product. “I don’t necessarily believe pension schemes aren’t already exposed to this sort of discipline, albeit within portfolios,” he says.
Small- and medium-sized pension funds are now getting better access to structured products, while the larger schemes, upwards of £1-2bn (E1.6bn) have tended to be more directly familiar with the instruments underlying these methods, having the in-house resources to deal with them.
For pension schemes, structured products are mainly about using instruments that protect the performance of the investments relative to the liabilities of a pension fund. “Trustees are increasingly realising that beating a benchmark or getting absolute return is not going to help them… it’s about matching the liabilities,” says Rastogi.
And it is not just trustees’ interests that stand to benefit from the alignment offered by structured products. In the new accounting environment, sponsors are also interested in keeping liabilities covered. “They both need something that’s related to their liabilities,” he says.
The products available fall into two categories. The first, where risk management is a major theme, is instruments that make a pension fund’s bond investment act as if it were a cash flow stream. This is achieved by using the swaps market to match duration.
“The swaps market is a very deep and liquid market that allows you to match a wide profile of financial risks inherent in the liabilities,” says Rastogi.
The second category is not just risk management, but aimed at producing excess return, for example, a portable alpha product. In practice this would encompass the use of riskier asset classes in combination with derivatives that match the liability profile.
Rather than simply choosing an off-the-shelf structured product, it is important that pension funds going down this route engage with an adviser, says Jack Berry, principal at PSolve. “If you’re going to tailor a solution for particular liability and risk/reward requirements, you have to make sure its attributes are relevant to what you need.”
Though it is possible to use generic products as a starting point. “For example, inflation and interest rate swaps or gilt-index swaps can be used to achieve the same economic result,” he says. “What needs to be looked at closely is how they’re put together.
“They have to be packaged in a way that reflects the nature of the scheme. From a governance perspective, trustees want to be taken through the process that reflects the uniqueness of the scheme.”
Although there has been a lot of discussion within the industry about liability-driven solutions to pensions investment, Rastogi says there is limited information as to how much of this has so far been implemented.
PSolve acts as an interface between pension funds and the various potential providers in the market, says Berry. This has many advantages from the client’s point of view when moving to implement such solutions.
“We can achieve this in a cost effective and transparent way,” he says. “There are varying degrees of transparency and fees from different providers.” Trustees need to be confident that the documentation and solution design offered by the providers will protect them appropriately, he says.
Thomas Zimmerer, senior consultant at Alpha Portfolio Advisers in Germany says, where pension funds are using structured products, it is mainly standard types of product such as equity index futures and bond futures for short hedging in overlay strategies. These are used for the purposes of portfolio insurance or absolute return, he says.
Among the products on offer are callable bonds. These are bonds which have a coupon enhancement by selling a call option. The bonds can be called in an environment of falling yields and rising bond prices.
“Many investors now have the embedded options deeply in the money and sit in the trap,” he says. “They will be, or are called, and they have to reinvest at lower yield levels.”
Providers are also offering derivative overlay strategies as an ‘add on’ to control asset allocation shifts or to protect a predefined downside risk that the investor is not prepared to bear. These overlays are mainly used in quantitative rules-based concepts, and they serve well in absolute return/protection strategies, says Zimmerer. They deliver a certain minimum return and avoid a predefined shortfall target for a predefined point in time, typically by the year end.
Or they can be relative return strategies, which deliver the better performance of two asset classes, for example bonds versus cash, or long bonds versus money market. This is an alpha developed strategy called Best of Two.
What is not being considered in the pensions field are stand-alone derivative strategies and long strategies.
“In many cases the use, or rather the low use of derivatives is a mixture of ‘don’t want, can’t, mustn’t or don't know,’ by the typical pension fund investor, since they are very conservative,” says Zimmerer.
“But we have also seen portfolios where the investor has used instruments where they don’t even know what the risk return profile really looks like. In general, there is a lack of know-how on the part of the decision makers which makes the instruments a priori either dangerous or interesting.”
Pension funds should think about
all the options before going to
investment bankers for a tailor-made product.
“If they should decide to implement a derivative based component they should fully understand before they decide,” he says. “They should check if they or their asset managers can generate the desired return profiles with liquid and cheaper standard instruments - swaps, future contracts - and tailor the use of standard instruments before they pay a lot to tailor-made concepts the investment bankers.”
How a fund should choose a provider really depends on the product or strategy, he says. “The range goes from sales contact for standard products through to manager search via consultants like us, through complex tailor-made overlay strategies for one portfolio, and on to the management of the entire asset allocation.”
Theo Kocken, chief executive of Cardano Risk Management in Rotterdam, says the pensions industry is more actively applying derivatives on a strategic level than a few years ago.
“Derivatives were already employed for tactical use by some pension funds in the 1990s, but a much broader group is now applying, or in the preparatory process of applying these products as part of their long-term risk management strategy,” he says.
He attributes this increased awareness by pension funds of derivatives - either directly or packaged in structured products - to a combination of two things. On the one hand, it is due to a transition to fair value, and on the other it is down to stricter solvency requirements.
The switch to fair value stems from two rule-based sources. Firstly the new accounting standards (IFRS), which apply to corporate pension funds in particular, and are based on fair value, and secondly pension regulations in many countries such as Denmark, The Netherlands and Sweden.
“Fair value calculations not only change the value of the liabilities, compared to fixed rate calculations, but also the basis of risk modelling,” says Kocken. “This implies the volatility of the pension funds has radically changed and the interest rate has become a dominant, but removable, part of the total risk.
Kocken says that hedging the real and nominal interest rate risk has gradually moved into the area of ‘how do we do this?’ instead of ‘why should we do this?’.
Areas of debate, he says, are the dilemma of hedging inflation risk or regulatory and accounting driven risk. But the solution is not always one or the other. In the case of the Netherlands, conditional indexation requires a specific answer. “In general a mixture between the nominal and real is risk-optimal,” he says.
For pension funds with a very low funding ratio, nominal hedging provides a large part of the solution, but for wealthier funds, a larger inflation-linked component should be incorporated.
“The optimal composition of the hedge can be obtained by using tailor-made asset liability models. In the UK, inflation linked solutions are more common and in Denmark, the hedging is almost only nominal based,” involving interest rate swaps and related products such as CMS floors and swaptions.
How does a fund implement interest rate hedges? Kocken says the way to do this, for both nominal and inflation linked, is via derivatives - typically swaps and swaptions - or securities. Both are available in nominal and inflation linked terms.
Securities have the advantage of being familiar to investors, but they do not provide enough hedge against the liability risks.
Swaps and related products such as swaptions, says Kocken, are the solution. “Derivatives have the advantage of more flexibility and allow for a much more tailor-made approach. Following a thorough implementation route, a derivative-based strategy can be both a effective and cost efficient risk management with high transparency.”
While for larger pension funds - a few hundred million euro-plus - the most obvious way to go is to tailor the solution in a going concern context, implementing the best solution in an asset and liability risk return framework.
For smaller pension funds that cannot tailor their hedge, but want to reduce their liability-driven interest rate risk, the best way is to invest in packaged funds that combine more liquid shorter dated bonds with swap extensions.
Some of the new rules for pension funds, such as the Traffic Light System in Denmark and Sweden and the FTK in The Netherlands, require solvency levels depending on the risk a pension fund runs compared with its liability profile.
Interest rate hedging reduces the risk and therefore the solvency. Where funds have no risky assets, liability hedging cuts solvency and real risk close to zero, but usually the funds retain a substantial amount of equity. In these cases there is some tension between the real, long-term risk and the short-term solvency requirements, which requires bespoke hedges.
Option strategies are applied to reduce extreme risks (and solvency). The best way forward, says Kocken, is a tailor-made derivative solution. “Second-best for smaller funds is to invest in the many capital protected funds and many other, more complex funds with limited downside.”
CPPI structures on hedge funds are a good example of this. “Costs are not transparent and - as goes with complex products - usually relatively high,” he says. “But for smaller funds, this is not necessarily an expensive choice compared to, say, taking dire measures such as moving the fund to a nominal insurance solution to meet regulatory requirements.”
Nick Horsfall, senior investment consultant at Watson Wyatt says the firm has a team of seven people implementing structured and derivative strategies for pension funds. In terms of what is being implemented, he says it is mostly inflation and interest rate swaps to reduce inflation and interest rate risk.
Credit derivatives and equity options are also being used. Credit derivatives are used with the aim of getting more diversified credit exposure, as the credit markets themselves are not very well diversified. “There are a lot of pension funds who are trying to take credit risk off the table,” Horsfall says.
The real advantage of using structured products and derivatives, is that it creates the flexibility to get a better trade off between risk and return.
However, this comes at a price. Horsfall says there is a whole range of costs involved. There are the legal costs of the documentation required, and higher administration costs of moving collateral about, for example. There are also more complex costs which should be considered, such as the trustees having to spend quite a lot of their time getting heads around the concepts.
“There’s not much transparency of pricing,” he says. “We spend quite a lot of the time getting clients to understand the embedded costs.”
The cost aspect of implementing structured solutions to investment problems means that, for some funds, it is not really worth it.
“There are a small number of pooled instruments. It just boils down to what a fund wants,” he says.
Case study one: Norsk Hydro
Runar Gulhaugen, investment manager at Norsk Hydros Pensjonskasse in Oslo, says his fund does not make use of any structured products in its investment.
“In general, I would say we are using the more simple, the cheaper products,” he says. The fund opts to invest in the real underlying securities rather than use any structured products created from derivative instruments.
Although the fund does use derivatives in some instances, this happens very seldom. However, it is not that the pension fund avoids using structured products on principle. It is just that in practice, they are not considered beneficial within investment strategy.
Gulhaugen agrees with the argument that structured products could, in theory, be useful as a way of safeguarding returns and thus freeing up the fund to take more risks in other areas of investment. “That is possible, but up to now we have found them relatively expensive.” This cost outweighs the advantages, he says.
Case study two: Fonchim
Likewise, Italian industry-wide pension scheme for chemical workers, Fonchim, does not use structured products or derivatives in its investment. And Fonchim director Andrea Girardelli is sceptical whether such products and instruments provide any benefit at all to pension funds.
He says the only type which might have any use is a stocks-based instrument which safeguards capital. “Personally, I can only conceive of a capital guaranteed product on an equity investment.” Whether the fund will make use of such products in the future is still open, he says.
Girardelli believes other funds, too, should be cautious in their use of structured products. “Use them in small quantities and only to make important leverage,” he advises.
Case study three: ATP
Denmark was the first western European market to retract the philosophy that savings institutions need more equities.
Other countries such as Spain, Portugal, France and Germany hardly accepted the thought but in the late 1990s Danish pension funds and insurers began raising their allocations to shares to keep future retirement benefits up to pace with rising longevity.
Then in 2001 the Danish Financial Supervisory Agency introduced a ‘traffic-light’ system of risk, where ‘green’ signified the fund could continue unchecked but ‘red’ meant that it had to reduce volatility or beef up assets to the regulator’s satisfaction.
A red light signalled that the fund’s reserves would not be able to withstand a 12% drop in equity prices; an 8% drop in property values or a fall of 0.75% in bond yields.
At the time, many questioned whether the regulator had overreacted to the savage bear market of the previous year. The consequent reduction of equity holdings by Danish savings institutions was seen by those UK and US asset managers still selling equity products as unfortunate.
But other countries, whether through legislation or market practice, are now following the Danish school of thought.
Hilleroed-based ATP has assets of DKK325bn (E43.5bn) for a membership of 4.5m Danes. Every worker pays some contribution to this supplementary state fund, and the unemployed have a contribution paid for them.
ATP does not have conventional pension fund liabilities; it is a kind of with-profits arrangement which has to generate around 4.5% returns after tax per annum for its customers. As such, it noted the mismatch of accounting standards and market valuations. Discounting expected future income at a fixed rate satisfied the accounts but was not meaningful. In seeking to manage risks present in its liabilities and assets more realistically, the fund had to take “an easy decision” of using derivates, recalls chief executive officer Bjarne Graven Larsen.
The derivatives were essential to reduce the fund’s duration risk, its sensitivity to interest rate movements. “Even if we had been able to buy all outstanding Danish government bonds, we could only have reduced our duration risk by two-thirds,” Larsen explains. So at the end of 2001 the fund bought euro-denominated 30-year swaps (there were no similar Krone-denominated swaps; the contracts were not hedged).
Larsen recalls the rate then was 5.3%. Now it is more like 4%, so ATP posted profits from the tactic of E711m in the first quarter of this year alone. But the CEO emphasises that there is no intent to win alpha from the policy. “This was not about adding alpha or tactical stuff; it was a long-term strategy to reduce risk,” he says.
On cost, he notes that swaps were cheaper than the primary options available – another incentive to take this route which many other savings institutions do not understand.
But then ATP has a large investment staff of around 70, half of whom are front office. So the Hilleroed fund can manage its own swaps programme, which is worth DKK31.1bn.
ATP does use intermediaries to trade. Larsen declines to name the US bank the fund used to transact its first swap but he reckons that four years ago local players were not capable of arranging such a deal. He believes Den Danske Bank and Nordea might now have the kind of relationships in place to be providers alongside the recognised bulge-bracket investment banks.
Other pension funds may not have ATP’s in-house numbers of investment professionals, so what does Larsen recommend for them when using derivatives. “There can be a time-squeeze if you have to hurry. If you can take your time, then you will get a reasonable price.”
Interest swaps are not the only kind of derivative with which ATP is familiar. It used equity futures to hedge market risk when it had to make serious cuts in its equity exposure three years ago under the new risk regulations. Specifically, Larsen recalls that the fund shorted or sold index futures to mitigate the effect of the forced selling by a host of Danish institutions.
ATP is happy to consider options for similar scenarios, to put a floor on potential losses or even pick up some money on the downside if markets are trading in a volatile fashion. The strategy bears some similarity to convertible arbitrage, where traders rely on the volatility of the stock outstripping the volatility of the convertible bond. Graven Larsen, however, has little positive to say about hedge funds.
He is clear that unlike the fixed interest swaps, using options tends to be part of a tactical view on the market and is about trading.