Remember 1995? Only 10 years ago or so, most investment managers still felt pretty uncomfortable with derivatives. Derivative traders were an exotic species using Greek symbols and a jargon nobody could understand. No surprise, pension funds hardly used these instruments, or even avoided them in principle.
What is a derivative? It is a security or contract whose value is derived from something else (an asset, index, interest rate, currency, commodity but also a sport result or the weather). In the meantime, futures, options, swaps and more complex forms of derivatives have made big inroads in investment, and this has sparked big controversies also in the pensions world.
One side feels derivatives are not appropriate for pension funds as they should only invest in something ‘real’. People are concerned about the short term, speculative nature of derivative trades (‘a zero-sum game with a big edge for the banks’) and the particular (or even systemic) risks connected with such instruments.
The other side argues that much greater use of derivatives should be made in the pensions investment process. They are not only useful for a more efficient portfolio management but also for generating higher returns. Most importantly, they are an essential risk management tools in modern times.
For a long while, investment banks thought they were pushing a string with pension funds. More recently, however, the ice seems to have been broken. There are a number or reasons for this:
o Derivative markets have become more mature;
o More regular use by other institutional investors (such as corporate treasury, insurance companies and mutual funds);
o Increasing familiarity with derivative strategies, in particular with recent graduates;
o Rising pressures on pension funds from all sides (regulatory, accounting standards, sponsors, members);
o The complete re-think of risk management in the pensions industry.
In a nutshell, the issue now is not anymore one of yes or no but about how to best use derivatives for pension funds.
From an academic perspective, the hostility to derivatives had always been a bit of a conundrum. Pension schemes typically have asymmetric risk preferences (i.e. avoiding losses is paramount), and derivatives can easily help you with protecting your portfolio from unwanted consequences.
One is tempted to say that pension funds are a very natural ground for the employment of derivatives. With the help of derivatives you can reshape the risk-return characteristics, maturities and cash flows the way you need, at least in theory. In practice, however, things have evolved a bit differently and derivatives have often crept in through the back-door.
Some fund managers started to push for more investment freedom in order to manage traditional portfolios more effectively. For examples, bond managers would make use of interest rate/bond futures and options on the grounds of flexibility, cost, liquidity etc. Similarly for equity managers with stock options or index futures.
Currency hedging has been another area of early and less controversial use of derivatives. Furthermore, trustees have also started to accept derivatives in special situations such as transition management.

A second area is rather new to most pension plans. Derivative instruments are, of course, a key ingredient in the management of ‘alternative’ asset classes, overlay strategies and structured products. Absolute return is a fertile field. Some prominent examples include:
o Hedge funds (and any highly leveraged portfolios);
o Commodity funds;
o Tactical asset allocation overlay;
o Currency overlay;
o Structured products (eg, guaranteed capital);
o Income enhancement.
There is a third, and most important, area where derivatives can be employed,ie, at the overall level of the pension plan. Some pension plans are more advanced than others in this respect. Let’s look at some interesting examples:
o Asset allocation. Trustees decide to shift the strategic asset allocation. Index futures can be used to do this rapidly, giving time for an orderly change of the underlying assets. Similarly, for portfolio rebalancing and more elaborate ‘dynamic asset allocation’;
o Portfolio protection. Useful in engineering ‘non-linear exposure’ to market movements or some form of ‘portfolio insuranc’;
o Asset-liability management. Do you want to have a better match of assets to (often long-dated, perhaps inflation-indexed) liabilities? Interest rate and inflation swaps/swaptions are instrumental in duration and cash flow matching;
o Solvency rules. The regulator introduces new funding requirements with certain time limits. Difficult to achieve without derivatives;
o Minimum return. Plan assets need to generate a minimum return every year? An area for derivative manufacturing;
o Sponsor’s covenant. Trustees and members are concerned about the sponsor’s ability to fund the DB plan. Credit derivatives may give a certain protection;
o Income requirements. Writing derivatives can produce additional income;
o Individual accounts. Concerned about the value of your DC pensions pot near retirement? It is easily protected.
Development is fast in all areas. It is difficult for pension plan directors to keep an overview on what is going on even in their own fund. Instead of being pushed by aggressive product-selling it is advisable for pension plan director to take a fresh, but calm, look at this from top-down.
What are the investment and risk management challenges? Where do we stand? Where do we want to go? What can derivatives do to solve our problems? One or more objectives from the lists:
o Efficient investment management (eg, using more liquid instruments);
o Risk management (eg, managing excess volatility; reducing mismatch risk);
o Return enhancement (eg,portable alpha; leveraging returns);
o Structuring risk-return
(eg, absolute return targets);
o Other objectives?
The decision about particular derivative strategies and instruments comes much further down the line. Should pension funds use, for example volatility or correlation swaps? When you are building a house you don’t start with selecting the shovel.
At what level are decisions involving derivatives made? Is there a strategic framework for the use of derivatives? How is it implemented and monitored? Given all the change and complexity, these questions form a good test of the fitness investment governance of any pension plan!

There are a number of important questions: How to find a tailor-made solution? Who will get involved (consultant, investment bank, manager, internal resources)? Is a particular strategy undertaken directly or indirectly? Are there contradictory strategies in place simultaneously (eg, portfolio protection and leveraging by a hedge fund manager)?
Derivatives may be useful in risk management, but they also carry additional risks that need to be managed carefully, for example, counter-party and liquidity risks. Some other prominent implementation issues:
o Compliance. Are instruments and procedures compliant with regulation and pension plan rules? Clear about tax implications?
o Execution and pricing. Is execution best practice? How to get fair and transparent valuation, particularly OTC instruments?
o Operations. Are back-office systems and resources of all parties capable to deal with the latest instruments used?
o Risk control. Is there appropriate risk management in place both with delegate fund managers and the pension fund?
o Performance measurement. Does performance measurement reflect the true exposure and impact of derivatives?
o Reporting. Is the reporting up-to-speed on derivative strategies?
o Costs. Are you aware of all the additional costs involved, including consulting, administration and monitoring?
Any of these areas can be a limiting factor, not only for the use of derivatives but also for the overall performance and success of the pension fund.
As for the derivative industry, recent developments have been encouraging but the standards demanded by institutional investors will only rise, in particular for transparency, competitive pricing and liquidity when most needed. In the end, it sometimes not the creative thinking that is in shortage but the economic underlying on which to base derivatives, eg, long-term inflation or longevity linked assets.
Georg Inderst is an independent consultant based in London, georg@georginderst.com

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