Heavy losses on equity portfolios and widening funding deficits are forcing a rethink of pension funds' approach, but trustees need to be equipped to manage derivatives exposure, writes Philip Alexander.
Prior to 2008, with inflation on the rise, defined benefit pension funds had focused increasingly on liability-driven investment (LDI). The funds used the inflation and interest rate swaps markets to invest strategically, hedging out exposure arising from pension payouts indexed to the cost of living.
On the asset side, the assumption was that equities and corporate debt would broadly achieve above-inflation returns over the long-term duration of the liabilities, with some limited tactical investment decisions over the top of the broader strategy. As of the end of 2008, according to the 2009 annual European asset allocation survey by pension consultant Mercer, 54% of UK pension fund assets and 42% of assets in Europe excluding the UK were invested in equities.
However, with the plunge in equity markets taking many indices back to levels last experienced a decade ago, those long-term growth assumptions have to be revisited. In the UK, this left the 7800 funds tracked by the Pension Protection Fund with an aggregate deficit of £242bn ($395.8bn) by March 2009, compared with an aggregate surplus of £65bn at the start of 2007.
"Most schemes have not benefited from the equity risk premium for the past 10 to 15 years," says Chris Wagstaff, head of investment training and development at Aviva Investors, where he trains pension fund trustees and other Aviva institutional clients. "If the equity market recovers and does return to its former levels, then I think schemes would look to take profit on their equity exposure rather than hedging it, and move into other asset classes," he adds.
Rebuilding funding ratio
In the meantime, however, funds still need higher returns in order to repair funding ratio deficits, and a defensive portfolio combined with liability hedging alone is not sufficient. "For those schemes that are underfunded, full matching would lock in the underfunding, which of course we want to avoid. But with equity exposure, there is always the risk of the deficit becoming worse if the market falls further," says Stephen Yandle, an independent pensions consultant who has worked for Swiss Re's pensions solutions team and is chair of trustees for the Vivendi Universal scheme.
"Companies forget they can die because of their pension fund - General Motors was just the first example, although obviously the pension fund was not the only reason; there are more and more corporate sponsors under pressure. We are going to see a change of culture in the way pension funds are run," says Serge Moulin, head of global solutions for financial institutions at Société Générale.
Re-entering equities aggressively at a time when the economic outlook is still uncertain is a dangerous game, however. "At the moment, the key is covering your risks, rather than taking on risk recklessly to plug the deficit," says Simon McClean, a former proprietary trader at Commerzbank, who is the chair of the investment committee for the bank's UK pension scheme. This trend has been intensified by the inclusion of pension deficits in annual accounts, so corporate treasurers are reluctant to take the long view on closing the gap.
"If the scheme is still active, it can perhaps just about afford the equity volatility, because it does not have a finite timeline. But for those that are closed to new members or are in run-off, there is obviously more need for hedging tools," says Mr Yandle, who previously worked in the corporate treasury of Vivendi.
Pension deficits and uncertainty about equity markets will oblige pension funds to become more comfortable with equity derivatives, to permit equity positions while hedging downside risks. "You need to get your funding position to 100% and a little extra. You don't need 30% upside, it is better to earn 15% and be protected from 30% downside, which you cannot afford even with long-term liabilities," says Mr Moulin, who originally qualified as an actuary.
The most common strategy for this purpose is an options collar, in which the fund sells call options to help fund put options. This minimises downside risks at the expense of capping potential upside. Alternatively, funds can use a put-spread strategy if they want to re-enter the equity market and believe any further falls will be limited.
"They might typically buy a put at 90% of the current market level and sell a put at 75% to finance it. So they are protected from 90% to 75%, but if the market falls below 75% they are not protected," says Robert Gardner, founder and co-CEO of pension and investment consultant Redington.
However, the optimum moment to hedge would have been before the heavy equity market fell - and not just because this would have mitigated the losses incurred during the past year. Higher volatility has also driven up the premiums charged on options, making the hedging process more expensive.
"Given the price structure of put and call options at the moment, it is quite difficult to construct something that would represent good value and provide the kind of returns that pension schemes require," says Aviva's Mr Wagstaff.
In view of the very specific needs of a pension fund, more tailored hybrid solutions can also be more cost-effective, by drawing together asset and liability hedging. "One solution looks at the relative pay-off between two indices. Pension funds are hurt most by falling nominal yields and falling equity markets at the same time, so this is a correlation product; in the event that nominal rates fall by more than equity markets rise, you are hedged. And, if they both fall, you are paid out double," says Mr Gardner.
Those funds that executed such deals at the right time have benefited significantly. SocGen's global solutions for financial institutions team took this a step further, using its large in-house correlation trading book to propose a full solvency put that directly hedges the fund's solvency position. "We found that the cheapest possible hedge was to take all the risks together, taking into consideration how they are correlated and also that the fund has net exposure to risks, such as interest rates, that are on both the asset and the liability side," says Delphine Rossi, analyst for pensions asset and liability management (ALM) advisory for the UK and Ireland at SocGen.
Mr Moulin adds: "We can also offer what we call a timer solution - the fund decides the budget of volatility for their fund, and the duration of the option will then depend on how quickly they consume that budget. If the realised volatility is lower than what is implied by the options market, then the hedge duration will be extended."
Synthetic exposure
Another more wide-ranging technique is to take equity exposure entirely through derivatives. The pension scheme for WHSmith in the UK pioneered this method in 2005 by selling all direct equity exposure and buying a call option on a basket of equities, to give itself some of the potential upside without any downside risk.
However, Jeroen Wilbrink, director of ALM for asset managers F&C Investments, understandably argues the case for active fund managers.
"If you overlay put options, they can just be based around the benchmark that you have given your asset manager. You are hedged, but the manager can still engage in active stock-picking by industry, company and country to generate alpha. If you move away to a fully synthetic investment strategy, it becomes very static," he says.
Synthetic equity exposure may become more important to pension funds because of the change in the structure of the inflation-linked market, says Mr Gardner of Redington. For the past 12 months, combined interest rate and inflation swap yields in the UK have been lower than those on inflation-indexed government bonds, encouraging pension funds to switch their inflation hedging strategy from swaps to gilts or corporate inflation-linked bonds, such as the UK government-guaranteed Network Rail paper.
But this means changing from an unfunded derivative transaction to a fully funded cash transaction. "We have suggested effectively liquidating the cash equity portfolio to raise cash to buy the matching bonds. Then they can synthetically replace the equities either by using exchange-traded equity futures or by entering a total return swap with a bank," says Mr Gardner.
The governance gap
Whatever technique is used, there is a general consensus that pension schemes will need to continue moving away from the tendency to give pension trusteeships to long-serving staff without regard to their financial qualifications. "Swaps are relatively straightforward instruments, but when you move onto calls and puts, an investment committee might find it difficult to make the necessary decisions - what is the right strike price to take, at or out of the money? Over what period should they be hedging, six months or further out? And what portion of the portfolio should they be hedging?" says Mr Wagstaff.
Most funds tackle this problem by using investment consultants. But, as more people with different levels of understanding of derivatives get involved, the decision-making process can become more cumbersome, says F&C's Mr Wilbrink. "We sometimes find we are working with the consultancy's client manager, rather than its derivatives experts. But at least the more we explain the transaction, the more clear it becomes to everyone on the client side what is involved," he says.
"For now, it is mostly the larger, self-managed pension schemes that are stepping up their use of equity derivatives. But thanks to LDI, trustees have become more familiar with the idea of using over-the-counter synthetic instruments. Today there is a great opportunity for schemes to hire well-qualified chief investment officers as investment banks and fund managers are letting good people go," says Mr Gardner.
There is a general consensus that the Dutch market remains the most sophisticated in Europe, with the UK following. But Mr Wilbrink says that even relatively conservative pension markets such as Germany - which had an 83% bond allocation in 2008 according to Mercer data - are now seeking to take on hedged equity exposure to plug funding gaps.
