All the noise surrounding pension liabilities and EU-wide reform has meant that asset liability management solutions have now become one of the hottest topics in the investment banking world. Natasha de Teran asks what role equity derivatives can play.
Pension liabilities are the bane of many corporates’ existence and a worry for people who are not blessed with solvent defined benefit schemes or a good pool of retirement assets to cushion them in their old age.
They are also a considerable concern for the governments of countries with ageing populations and workforces that still believe the state will provide for them – especially if corporate or private schemes fail.
Equally, they are a headache for the managers of pension funds, who have to struggle as best they can in the confines of strict mandates to deliver the sort of healthy returns that are required to keep the funds solvent. And they are no blessing for the regulators that have to design a framework for the future health of pension plans.
However, the pension industry’s current state of flux has come as a blessing for at least one group of people: equity derivatives practitioners could not be happier because the solutions to the existing problems lie in their grasp. Equity derivatives technology can help these funds or their parent firms to meet the changing regulatory requirements, match liability targets and answer the asset-and-liability conundrum. Or so the practitioners claim.
Derivatives solutions
Johan Groothaert, global head of the investment products group at Deutsche Bank, says that in the early 1990s the equity derivative markets would not have had the capacity to deal with the volumes necessary to hedge out these funds’ positions. But, fortunately for businesses like his own, he says the situation has since changed and it has become imperative to use these derivatives solutions in asset liability management (ALM).
“The whole story about ALM at the moment is about the industry realising that it makes sense to subcontract the risk management to banks’ derivatives divisions. They are not only the most experienced in managing such risks, but they also have the capability to offset and redistribute those risks,” he says.
Essentially, new European Union reforms are driving managers to better manage their assets so that they can link their investment performance to match their liability requirements more effectively. Christophe Pochart, the head of equity derivatives financial engineering-insurance and pension group at SG CIB, says there are many higher-yielding investment opportunities that can help managers to do this but these, naturally, tend to be more risky than their less volatile alternatives. “Equity derivatives – and particularly structured asset management-based products – can offer a real solution to these issues because we can design the products around their exact needs and deliver them in a relatively simple form,” he says.
Growing recognition
Remi Frank, global head of equity and derivative sales at BNP Paribas, agrees equity derivatives can play a tremendous role in this area. “Increasingly, insurers and corporates with pension fund liabilities have begun to recognise the value in using tailored structured solutions to help match their liabilities. The pension funds themselves are also slowly becoming receptive to the idea,” he says.
Hassan Houari, head of equity structuring at Barclays Capital, is equally adamant about the important role that equity derivatives have to play in ALM solutions. He points out how the UK’s FTSE 100 firms, for instance, are under-funded on their pensions to the tune of about £40bn. “Given that 60%-70% of their allocations are in equities, the sort of solutions that are and will be designed to address this issue will, quite naturally, be based on equity derivatives in combination with interest rate instruments,” he says.
Hassan Houari, head of equity structuring, Barclays Capital
The sort of equity derivative-based hybrid solutions that these users have already taken up considerably have included interest rate, inflation and equity hedges for periods of up to 10 years. “These can be adapted to suit the exact profile of each entity, and help to match up the assets and liabilities far more closely and in a far simpler way – from the end user’s perspective – than might otherwise be achievable,” says Christian Kwek, European head of institutional structured product sales at BNP Paribas.
Modelling work
Mr Pochart says SG’s insurance and pension group works to find solutions for these firms by first obtaining and then pooling all the information the client has on its assets and liabilities.
SG checks and monitors this and then models it, examining the relationship between the two and identifying areas where it can offer matching solutions.
Mr Pochart claims that banks like SG do not compete directly with the growing ranks of pensions consultants, although their models are superior. They are more sophisticated on the asset side because the models benefit from the bank’s expertise in measuring and managing complex risks on different assets and financial parameters.
In devising ALM solutions, Mr Pochart says it would be almost impossible to avoid using equity derivatives technology and products. “They are absolutely necessary to reconcile long-term performance objectives over short-term regulatory constraints. These managers need not only outperformance from their equity investments, but also protection against the associated downside risk, and the only way to provide this is through structured equity derivatives-based solutions,” he says.
And to settle any concerns potential users may have about the dark alchemy surrounding the products, Mr Pochart says: “These are not black-box solutions, they are totally transparent.”
Dixit Joshi, head of equity derivatives at Barclays Capital, believes that an increasing amount of activity in the equity derivatives business will be driven by pension funds. The ongoing challenge for equity derivatives practitioners will be to identify and provide integrated ALM solutions for these firms to meet the changing regulatory requirements.
Dixit Joshi, head of equity derivatives, Barclays Capital
That may generate some lucrative business but it is no easy task and will become more complicated if corporates’ credit quality deteriorates or pension funds fail to rebuild asset value significantly. Pension fund beneficiaries must hope they can continue to find solutions to these problems.
