UK - The use of derivatives by UK pension funds more than doubled last year to £20bn (€29.8bn), according to estimates by international consultants Watson Wyatt, who issued a warning that such structured solutions were not for every fund.
While the size of the market is hard to measure, since most deals are done privately between investment banks and investors, the consultants said the UK market was estimated to be around £9bn in 2005 and £3bn the year before, based on estimates by a number of banks.
In 2006, Watson Wyatt's structured products team advised on £13.7bn of executed transactions with banks, of which £12.4bn related to managing interest rate risk, typically involving inflation and interest rate swaps and swaptions, which are options to execute swaps. The figure for the previous year was £7bn.
The remaining £1.3bn of transactions in 2006 related to the use of equity options used to manage equity risks.
"Pension fund de-risking and low bond yields are motivating many trustees and their sponsors to use various derivative instruments,' said Nick Horsfall, senior investment consultant.
"However, these structured solutions are certainly not for everyone and indeed, we have been advisers in many cases where transactions are not supported based on our analysis."
He also said that the use of derivatives required significant governance resources. "Only those trustees who can combine the necessary time expertise and organisation will make the most of more elaborate investment solutions."
Pension funds have some questions they must answer before entering derivative-based strategies, said Horsfall. "This included legality for use, pricing transparency in the product, whether any proposed solution is appropriate and if the counterparty bank - through contracted terms and collateralisation - can be relied upon to deliver their promises."
The consultants said that much of the demand for these liability hedging solutions have come from large UK based institutions, many in the financial services sector. "There has also been growing interest from Europe and the US," the firm added.