Derivatives can enable pension funds to re-shape their asset returns. They can guarantee an upside and protect the downside. Crucially they provide a closer match than bonds to a mature pension fund’s liabilities.
The use of derivatives by pension was one of the key themes at Watson Wyatt’s 11th annual Global Asset Study for pension fund managers in London. Paul Trickett, consultant in the investment team at Watson Wyatt in Leeds said that swaps are arguably the most successful financial innovation ever. The swaps market totalled $169.8trn (E138.7trn) in mid 2003.
Swaps, an agreement between two parties to exchange cash flows in the future, provide pension funds with highly flexible risk management and return-shaping instruments, he said. However, take-up by pension funds has been relatively small. Only nine Watson Wyatt clients have implemented a swap arrangement.
Swaps can also provide a rewarding alternative to gilts. A pension fund could buy a 10-year gilt that would yield 5.06%. However with the same cash it could buy a 10-year swap yielding 5.23%. In the swap, the pension fund converts cash assets at LIBOR into a known fixed payment, which can pay liabilities, in this case for 10 years. The investment bank offsets the swap, receiving 5.28% and leaving it a turn of 0.05%.
Inflation-linked swaps can also match index-linked liabilities, Trickett pointed out. The investment bank finds a source of inflation, typically from utilities. The pension fund buys this inflation, the bank makes its turn, and the fund pays its inflation-linked liabilities.
The crucial point is that swaps can change the shape of the assets. “Swaps give pension funds the opportunity to change the shape of the asset cash inflows to be closer to the benefit outflows,” Trickett said.
A good example is inflation-linked swaps. Normally a pension fund will hold indexed linked bonds to moderate pension fund risk. However, allocating to index-linked bonds still leaves some investment risk, and is unlikely to allow efficient credit allocation.
Derivatives also enable a pension fund to create index-linked credit, not normally available to pension funds, he said. Under this arrangement the pension fund supplies the financial institution with a source of inflation - the index-linked gilt portfolio. The fund then chooses a portfolio of corporate bonds and enters into an inflation swap, netting the index-linked gilt return plus the corporate bond yield pick-up.
However, there are substantial technical and legal challenges. “It takes longer than you think and it still isn’t comfortable,” Trickett says. “It needs close discussion with the actuary to confirm the action of a strategy on the funding of the scheme.”
Pension funds should also consider using options, suggested Nick Horsfall, senior investment consultant at Watson Wyatt. Options are a contract between two parties where one party has the right, but not the obligation, to transact in the future. They can be used to manage risk and/or generate income. In this respect options can be thought of as a means of changing the return profile of assets already held on a pension fund balance sheet, said Horsfall.
There are two types of options – calls and puts. A call option gives the holder the right to buy the underlying asset for a certain price on a certain date. A put option gives the holder the right to sell the underlying asset for a certain price on a certain date.
Pension funds can use call options in two ways, said Horsfall. One way is selling call options against holdings in the portfolio generates an income from the premium, the price of an option paid by the buyer of the option to the seller. Capital returns may not be as high as if they had stayed in equities, but there will be a definite increase in income. The other way is buying call options. This provides exposure to the asset without the risk of the asset performing poorly.
There are also two ways for pension funds to use put options. Selling put options while holding cash gives a premium income. Buying put options against holdings in the portfolio provides protection against the asset performing badly. It is possible to use both puts and calls to limit the downside while guaranteeing an upside.
Pension funds should look at derivatives because they have liabilities that are more bond-like than equity-like, Horsfall said. Options enable a pension to ‘sell’ the value of any equity market upside. This can be structured to be relative to bonds, of particular interest if the plan is planning a move to bonds anyway.
Finally, options provide a useful way of preventing pension fund trustees from chopping and changing the asset allocation.

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