Derivatives-based solutions aim to solve ALM mismatch

The pension fund industry has historically been known for adopting conservative investment policies rather than for having an advanced appetite for complex derivatives solutions. But investment bankers are increasingly targeting managers and corporate pension providers with derivatives-based solutions.

The rush to service pension funds with derivatives-based solutions is neither arbitrary nor ill timed but has been staged to overlap with the introduction of new and more rigorous rules surrounding the funding and accounting treatment of derivatives, and it also coincides with a growing concern about falling pension assets and growth in future liabilities.

According to investment consulting firm Watson Wyatt, the growth in total institutional pension fund assets in 2004 in the 11 major markets stood at just over 7%, when the growth in global pension fund liabilities increased by approximately 10%. Managing that asset and liability mismatch is something that bankers experienced in tailoring derivatives-based solutions believe they are uniquely well placed to offer. And they claim that uptake of their offerings is flourishing.

Structured solutions

Rémi Frank, global head of equity and derivative sales at BNP Paribas, says that until recently, pension funds have been quite conservative and are only now becoming receptive to the idea of structured solutions, even though their peers in the insurance world have used these for some time.

Eric Viet, European head of the insurance and pensions group at JPMorgan, agrees. “The insurance companies have traditionally been the more aggressive users of derivatives, but the pension funds are increasingly beginning to contemplate derivatives-based strategies and give freer mandates to their asset managers,” he says. According to Mr Viet, the changing accounting rules, the shifting regulatory landscape and today’s particular economic environment have all contributed equally to this shift in appetite.

 Eric Viet: Pension funds are contemplating derivatives-based strategies and giving their asset managers freer mandates

Plain vanilla choice

While insurance funds have already used swaptions and caps quite widely, pension funds have tended to use more plain vanilla interest rate swaps solutions, says Guy Coughlan, global head of asset liability management (ALM) advisory at JPMorgan. However, because pension funds are now giving mandates to external managers to handle, he expects to see more of them begin to use alternative derivatives strategies He has already seen some interest in tailor-made hybrid hedge structures from these firms. These, he says, might embrace hedges for equity, credit, interest rate and inflation exposures in one.

Christophe Pochart, head of equity derivatives financial engineering-insurance & pension group at SG CIB, believes the solutions best suited to pension funds’ needs come from structured asset management-based products. He says these can offer a more meaningful solution to their exact issues, as banks like his own can design the products around their particular outperformance and hedging requirements, delivering it to them in a relatively simple form. These dynamically managed solutions might encompass real estate exposures, along with the more traditional equity, inflation and long-term interest rate hedges, depending on requirements.

Ines de Dinechin, head of corporate sales Europe for fixed income and derivatives at SG CIB in Paris, claims that pension funds are now beginning to use all the different markets at their disposal to hedge their risks. Long-dated bond and swap markets are developing and she believes a market in longevity risk could also emerge.

For banks with strong derivatives and structuring skills the pension fund ‘problem’ is a welcome one. They hope that sorting out funds’ asset and liability mismatches will enable them to offer cross-product solutions – exploiting their strengths, delivering on their much-vaunted synergies and bringing in revenues to diverse departments. Ms de Dinechin says that providing these solutions demands input from all sorts of business lines within a bank – from interest rate and inflation traders and structurers, to debt origination teams, equity derivatives and asset management professionals.

Is some of this just wishful thinking? Watson Wyatt advises more than half of FTSE 100 companies and last year saw a 40% increase in the number of swap transactions employed by the UK pension funds that it advised the previous year. But, according to Nick Horsfall, a senior investment consultant at Watson Wyatt, there has been scant evidence of more structured or dynamic solutions being employed by any of them. Mr Horsfall says that in the past two years, his group has been involved in executing a “very good number” of inflation or interest rate swap overlay trades – and many more exchange-based derivatives transactions on behalf of pension funds – but little more than that.

Simple overlays

“We haven’t seen a lot of interest in dynamic hedging solutions – not that there is anything wrong with them – but predominantly these entities are looking for simple overlays,” he says. “At present, their primary aim has been to get fully funded, to hedge out their inflation and interest rate risks and to leave it at that. Certainly, no one I have spoken to has gone for any of these complex dynamic solutions.”

Mr Horsfall says that he has seen evidence of banks trying to offer unwitting pension funds some inappropriate structured products, but that this activity has now fallen off.

“These were very complex solutions, which had a lot of hidden costs within them and which were not very well targeted at client needs, but this is becoming increasingly rare now, perhaps because there was no appetite for them anyway. In general, the banks are being very professional in their approaches and work on the basis of looking for long-term relationships, rather than highly profitable one-off transactions.”

It is for such reasons, Mr Horsfall says, that it important for pension fund trustees and managers to seek external advice before engaging directly with banks – and he says, they are. “Clients are increasingly coming to us after having been approached by banks with ideas. They ask us to review it for them, and if they want to go ahead, to do the due diligence to ensure transparency and fair execution. Occasionally, there has been very poor pricing which has changed rapidly once we have introduced tension into the pricing.”

Appropriate documentation

At other times, clients engage Watson Wyatt directly to identify tools that will be helpful in reducing risks, improving returns or both, and it then works with clients to select the appropriate documentation and trading counterparts. “Sometimes we also might give them a second opinion on pricing, while at other times we advise on the trade itself or the surrounding framework, but our preferred our approach is to engage in thorough background and research with our client and develop a solution on the back of that. Once this has been designed, we might suggest a short list of potential counterparts and provide advice on the pricing and terms.”

Whatever these pension funds are doing – and there is clearly a mismatch between the experience of the investment banks and the consultants – the problem is a growing one. It is also one that presents a unique business opportunity for both constituencies. A February investment review conducted by Watson Wyatt’s global head of investment consulting, Roger Urwin, showed that pension liabilities represent more than 30% of the market capitalisation of a typical German company and around 20% for typical UK and Japanese companies.

Buyers of innovation

Like the bankers, Mr Urwin expects pension funds increasingly to become “buyers of innovation” and to consider derivatives-based strategies to meet their liabilities. “In the past, some saw these strategies as too complicated, too dangerous or simply as offering no financial advantages. But as funds and their sponsors search for more effective ways to manage risk, they are realising that derivatives can alter the nature of that risk in ways that are not possible in the cash markets.”

Aside from the more traditional interest rate and inflation swap overlays, which he agrees are still the most commonly used derivatives products, he points to several other derivatives-based strategies that are likely to see uptake in the future. He adds that pension funds that face the risk of corporate sponsor default could neutralise this risk by buying protection against any funding deficit in the credit default swap (CDS) market. And pension funds that would typically only invest in a limited national universe of credit products could use the CDS market to diversify their fixed-income portfolios by selling protection on other issuers to other corporate bond holders, thereby taking on a new set of credit risks in exchange for a regular premium.

In this way, they would gain exposure to the creditworthiness of different bond issuers without being exposed to currency and interest rate risk, as they would if they bought the bond itself.

Alternatively, they could buy foreign denominated bonds to gain exposure to a more diversified pool of issuers, and then use currency swaps to turn these cash flows back into their domestic currency. But, Mr Urwin warns: “There are some derivative strategies offered to pension funds that we have generally found fiduciaries to be less enthusiastic about. Structured credit arrangements, such as collateralised debt obligations (CDOs), are very complex and can be quite opaque. And, in general, there are potential problems with any structured product that includes options or optionality, because the risk/return payoffs are asymmetric and they may react to changing economic conditions in unexpected ways.”

Cautions aside, he believes that change is in its infancy, but that “it will be big”– suggesting that bankers that have been developing capabilities ahead of time are doing the right thing.

“These new techniques call for new players and new skills. It is possible that pension funds, in employing professional specialists, will divide the responsibilities for managing risk and return differently in future. Investment banks are edging into the space traditionally occupied by investment managers, fund of funds players are growing, consultants are exploring new strategies and managers are developing different niche strategies, all to meet their clients’ needs.

“What funds need, though, is a better joined-up proposition from their line-up of providers – in short, better teamwork.”

If the banks can achieve that, then it seems they are indeed on to a winning proposition.