The pension fund environment
has changed tremendously
over the past few years, with
long-term objectives tending to be
replaced by a shorter-term focus.
These changes have been predominantly
driven by new accounting
standards, evolving regulation and
particularly adverse financial markets.
The new IAS 19 accounting rules
have repositioned corporates’ pension
exposure directly on their balance
sheet with a mark-to-market
approach. This in turn has led many
to focus more on the way pension
fund assets and liabilities can fluctuate
on a short-term basis.
In addition, the European
pension fund directive and current
European regulatory reforms
have exacerbated the risk management
approach which pension
funds are required to adopt. The
pending nFTK regulation in
Netherlands, the rules recently
released by Sweden’s Finansinspektionen
and the 2004 UK Pensions
Act illustrate the drive towards a
more stringent environment where
market crash scenarios are envisaged
at any time.
And the particularly adverse
equity and interest rate markets of
earlier this decade have shown that
situations which were previously
expected to happen once every 100
years or so could actually occur
twice in a row.
Accordingly, the way pension
funds allocate their assets between
traditional asset classes such as
equity, bonds and real estate is
under question. Some market participants
talk about ‘de-risking’
strategies in order to limit shortterm
volatility arising from the pension
funds’ equity and interest rate
exposures.
We rather think that pension
funds need to keep their long-term
stance in the interest of pension
beneficiaries. To achieve this in
optimal conditions, pension funds
are increasingly turning to investment
solutions developed by
investment banks.
For years banks have been developing
risk management approaches to
respond to their own internal needs.
Indeed, they faced similar regulatory
pressure some years ago and have built
up strong internal risk management
procedures to cope with the financial
risks they had on their balance sheet
arising either from retail banking
activities or from trading books.
Accordingly, to carve-out their risk
profiles they have used instruments,
such as derivatives, which have
become very liquid and flexible risk
management tools.
Starting in the mid-1990s, investment
banks designed asset-liability
solutions for insurance companies,
such as duration hedges or protection
against adverse surrender
shock from policyholders. Hence,
interest rate swaps or option-based
strategies have been widely
adopted by insurance companies to
enhance their asset-liability positions.
Interest rate swaps have been
used to adjust the duration and
convexity profiles of assets to
better match expected liability cash
flows. These instruments could
make sense for pension funds,
which have high interest rate sensitivity
and when long term bonds are
still very scarce.
As a result, investment banks have
widely marketed the use of derivatives
as efficient tools to manage
asset-liability positions and reduce
risk for pension fund clients. While
swaps are efficient tools to freeze
interest rate exposure and lock-in
forward rates, option-based strategies
allow pension funds to limit
downside risk and at the same time
keep asset-liability upside potential,
which could be fuelled by a rise
in interest rates.
De-risking or matching strategies
do not fully address such current
pension fund needs as generating
long-term steady returns with limited
short-term assets-liability
volatility.
The sale of the whole equity
pocket to buy gilts and interest rate
swaps in order to match current liabilities
is not the solution to resolve
this conundrum. Such investment
strategies would lead to the crystallisation
of any asset shortfalls and
limit the capacity of the assets to
outperform liabilities as the assets
would be used to buy bonds and
swaps.
To address the need for an efficient
use of available cash,
investment banks have tried to
deliver solutions to institutional
clients through structured products.
These reflect an effort to combine
exposure to more or less innovative
asset classes, with the possibility
of risk protection such as capital
guarantee at maturity.
They have also contributed to the
development of new total return
investments through the concept of
‘hidden assets’. Hidden assets correspond
to assets that are not
directly investable in the markets
like stocks and bonds.
For instance, hidden assets can be
the exposure to correlation or
volatility, which have historically
proved to be uncorrelated to traditional
asset classes. Insurance companies
have also used these products,
with structured products providing
exposure to the volatility of
equity markets or the steepness of
the yield curve proving particularly
popular.
Structured products could further
widen the investment universe
available to pension funds, along
with equities, bonds and also other
asset classes such as private equity,
commodities and hedge funds that
can be valuable investments from a
diversification angle.
However, derivatives and structured
products also have their
drawbacks. Over-the-counter
derivatives are complex to use
because they require specific legal
expertise, collateral management,
etc. Further, investors are puzzled
when asked to integrate derivatives
into their mainstream investment
processes.
Structured products have been
driven more by sound-but-shortterm
tactical considerations rather
than a long-term fit with pension
fund other assets and liabilities.
Some investment banks have been
building bespoke solutions at the
crossroads between pension funds
assets-liability management, structured
product technology and asset
management, that embed risk-mitigating
derivatives strategies with
exposure to assets which provide
upside potential.
They have merged the focus on
pension fund requirements,
which were inherent to the
design of derivative-based riskreduction
strategies, with the
return benefits of structured products.
The structured investment
solutions that derive from this
approach are easy to invest in, transparent
and specifically designed to
fit pension fund situations.
Accordingly, to address the need
for long-term investments in a
volatility-constrained framework,
new generations of structured
products are capable of providing
bespoke risk-profiled solutions
with protection against adverse scenarios,
while ensuring the capacity
to deliver performance.
Their benefits come from a capacity
to carve out risk/return patterns
in order to reach totally different
risk profiles from those obtained
when combining traditional asset
classes.
This approach is complementary
with investments in traditional
assets and offers far more opportunities
than de-risking strategies,
which would lead to lock-in historically
low interest rates, while limiting
the cash available to invest in
total return strategies.
Christophe Pochart is head of GSFI
and Jean-Marc Piques is executive
director at GSFI. Société Générale
Corporate & Investment Banking
Global Solutions for Financial
Institutions

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