GLOBAL – A new academic study says options can be used to make defined benefit pension schemes more sustainable.

“Properly constructed option strategies can add substantial value to pension fund management,” the study says. “Incorporating options appears an efficient way of improving ling-term pension fund health and there for the sustainability of defined-benefit pension plans.”

But the authors make it clear that the optimal strategy should be determined in an asset-liability context and not on an ad hoc basis. “The intuitively most appealing strategies are not necessarily the best strategies,” they say.

“Different pension funds require significantly different option strategies. What works well for one fund may be less effective or even counter-productive for another,” say the study’s authors Huub van Capelleveen, Harry Kat and Theo Kocken.

Van Capelleveen and Kocken are director and chief executive respectively of Rotterdam-based Cardano Risk Management while Kat is Professor of Risk Management at the City University in London.

They say that in the current debate about the pensions crisis little is being said about the investment process that links contributions and pensions. They suggest it is prudent to “first investigate whether pension fund health can be improved by changing the way in which pension funds invest before calling out for a rise in contributions and/or the slashing of pension rights”.

And they point to “overwhelming academic evidence” that active management adds only costs not value. They also point the finger at the pension funds themselves, for stubbornly sticking to traditional asset classes while ignoring newer risk management products.

“The obvious question that arises then is whether and how pension funds can use these new products to their advantage,” they ask.

They use a scenario-based pension fund asset liability management model to study the impact of a number of options strategies on the risk-return profile of a defined-benefit pension fund – focussing on the reduction of “extreme risks”. They key, they say, is for a realistic ALM model as the core tool of analysis.