Who's afraid of the D-word?

Derivatives - the portmanteau word for futures, options and swaps - send shivers down the spines of the boards of many pension funds, who see them as too complicated, too expensive and too risky.

Yet derivatives offer a way out of the difficulties that pension funds face in the current economic climate when they attempt to match their liabilities to their assets.

In some European countries, pension funds’ use of derivatives is well established. Danish pension funds, in particular, have employed CMS floors, an interest-rate option providing a floor on future reinvestment returns, largely in response to regulatory pressures.

In the UK and the Netherlands, insurers and pension funds have shown a strong interest in long-dated interest-rate options to protect their long-term portfolio yield.

But in other European countries, take-up has been less marked. Some pension funds are limited by investment restrictions. Swiss pension funds, for example, may invest in derivatives only for the purpose of hedging. However, it seems that many pension fund boards are able to use derivatives but choose not to, either because they are worried about the risks or because they do not know enough about derivatives to authorise their use.

Currently only the larger pension funds, with more sophisticated investment strategies, are likely use derivatives. Is this situation likely to change? Will the use of derivatives by pension funds become more widespread, or will their use continue to be limited? We wanted your views.

A majority of the managers, administrators and pension fund trustees – two out of every three - who responded to our survey say they already use derivatives in their pension funds’ investment strategy, although some use them only for hedging purposes.

Regulatory pressures, particularly solvency requirements, have been one of the main reasons for the use of derivatives by pension funds, notably in Scandinavia and the Netherlands. Most respondents, five out of six, agree that these pressures are likely to force pension funds to make more use of derivatives in the future.

The slow take up by pension funds has been blamed on the fact that derivatives are complicated financial instruments which baffle most pension fund boards. Many of our respondents agree. Two out of three think that the main obstacle to the widespread adoption of derivative instruments by pension funds is their complexity

However, a substantial minority disagree. The manager of Austrian pension fund manager blames “a lack of education,” while the manager of a Dutch fund says, “the level of board education is not always sufficient.”

There are other obstacles, our respondents suggest. A UK pension fund manager says complexity is a significant factor but not the main obstacle “There is also a concern about risk, if the parameters are not set carefully.”

Liquidity is also a problem. The manager of a Danish pension fund points out that “the other main obstacle is the market illiquidity of the instruments and consequently the high costs associated with the instruments”.
Asset managers and investment banks who find it difficult to sell their structured products to institutional investors will complain that pension funds are reluctant to use derivatives because they are naturally ‘conservative’ institutions.

Opinion here is broadly divided, with a slight majority agreeing

Some, while agreeing that pension funds are conservative institutions, do not link this with their caution over derivatives.

Some feel that blaming pension funds for being conservative is too simplistic: “A lack of understanding is the main reason,” says one manager.

The manager of a Dutch pension fund suggests that much will depend on the composition of the pension fund: “If the board is composed of older people this may be true, but in other cases it is not.”

Perhaps pension funds are right to be conservative. The use of derivatives carries its own risks, in particular counterparty risk, and most respondents, two in three; think that pension funds have good reason to be cautious.

“There is still a certain lack of transparency,” a Swiss pension fund manager observes. An Austrian pension fund manager sums up pension funds’ caution with the old warning “caveat emptor”.

It could also be argued that pension fund boards would be in breach of their fiduciary duty if they authorised the use of financial instruments that they did not themselves understand.

A majority of our managers. two in three, agrees. Some agree vehemently. The manager of a Danish pension fund, for example, believes that such a breach should lead to the resignation of the offending board members.

Yet for some the answer is not clear-cut. A Dutch pension fund manager says that there is something to be said on both sides of the argument. “You should not go into areas where you do not have the knowledge or the proper advice to go. On the other hand you should explore ways to better fulfil your fiduciary duties. This implies the need to search for a better investment portfolio.”

Another Dutch pension fund manager suggests that to demand a full understanding of the workings of derivatives is unreasonable: “Complete understanding will never be the case, so you have to take a calculated risk.”

And a substantial minority, one in three, do not agree that authorising the use of derivatives without fully understanding how they work action is a breach of a pension fund board’s fiduciary duty.

An Austrian pension fund manager points out that that pension fund boards do not need to understand derivatives in detail. What is important is that they understand enough to be able make the right choice of derivatives practitioners: “Pension fund boards can and will learn the basics so that they can select skilful people.

“A UK pension fund manager makes a similar point. “Provided they have taken advice and are clear abut thee risks and how they are being controlled, they do not need to know exactly how they work.” As someone once said of encyclopaedias, ‘it knows and therefore I needn’t.”

So are investment restrictions on the use of derivatives an unnecessary constraint that can safely be removed? Or are they necessary checks that should be retained?

A majority of our managers, two in three, have no doubt that some restrictions are necessary. “There should, of course, be guidelines for such types of investments,” a Danish pension fund manager states.

“Investment restrictions are necessary in the use of derivatives,” a Dutch pension fund manager affirms. “As with other investments there needs to be a goal and guidelines wherein you can be active to achieve the goals.”

A UK pension fund manager suggests that the need for restrictions will depend on the way derivatives are used. “Using derivatives in one way is a very sensible way of controlling certain risks, but using them in another way can add substantial risk. Removing restrictions could make it too easy for the second kind of risk to be taken.”

The use of liability driven investment (LDI) strategies is introducing an increasing number of pension funds to derivatives as risk management tools. “Derivatives are all the more necessary now as tools to manage risks, and in several LDI strategies derivatives are already used in the form of swaps,” a Dutch pension fund manager observes.

It has been suggested that pension funds should be allowed to use derivatives only for hedging purposes. This gains little support from our respondents, two out of three,

Yet a Dutch pension fund manager points out that the term ‘hedging’ needs to be defined: “A pension fund invests to hedge its liabilities. We think the use of derivatives begins with risk management, for hedging purposes. After that you can use derivatives to optimise within an existing investment portfolio and see whether actual or synthetic investment is ‘better’ in terms of efficiency.”

While using derivatives for risk management is okay, he suggests, using them to optimise returns is more questionable. The risks of derivatives are real; in particular the risk that counterparty will fail. One way that pension funds can avoid counterparty risk is to invest in pooled products, such as buckets of duration. Most managers agree that the use of such products is likely to encourage an increasing number of pension funds to use derivatives in the future.

Similarly, pension funds’ appetite for inflation-linked and interest-rate swaps, which grew rapidly last year, is unlikely to diminish. A substantial majority of managers, five out of six, believe this growth will continue in 2006.