The popularity of overlays is increasing in the US despite concerns of executive committees.
Leverage is something of a dirty word in the world of pension funds and that, perhaps, presents the biggest challenge that pension fund managers face when seeking to persuade their companies’ executive committees to use overlays that use derivatives as a fund-management tool.
At a roundtable of pension fund managers arranged by the NeuGroup, one participant said his team had begun to explore how to “de-risk” the plan more than three years ago, using a derivative overlay to hedge liabilities as one tool.
- But the executive committee said no to derivatives and the leverage they often include. “So we had to go through an education process on their timeline. Since then, rates fell 50 basis points, and committee members asked, ‘Have you put on the overlay yet?’”
Laugh line. That produced chuckles in the room and prompted other roundtable participants to chime in about the difficulty of convincing executive committees about the benefits of overlay strategies. Such strategies use derivatives like swaps and treasury futures to gain, offset or substitute specific portfolio exposures beyond the portfolios’ physical assets.
Overlay rising. A banker attending the meeting noted that 10 years ago, few if any plans in the UK used overlay as a part of liability driven investment (LDI) strategies, but today nearly all do. He added that the approach has crossed the Atlantic, with a recent survey showing 75% of US plans using overlay compared to less than half five or so years ago.
An overlay argument. LDI strategies aim to accrue sufficient assets to cover all current and future liabilities, often requiring derivative overlays when physical assets are insufficient or inappropriate. Another member said that rolling out an LDI program generated “quite a discussion” with the executive committee.
- Her team framed its argument by noting that the company’s greatest risk in terms of expense management and cash flow is its funded status volatility, emphasizing that implementing an LDI program reduces such volatility, even when derivatives introduce leverage.
Counterparty concerns. Aside from leverage, another issue stemming from overlays is the counterparty risk of over-the-counter swaps, a big concern during the financial crisis. But new regulations require daily margin calls on all the derivatives used, and “that risk has essentially gone away,” noted a roundtable member.
Leveraging up only assets is problematic. In an asset/liability context, however, using derivatives to increase the duration of the pension fund’s asset pool to offset the fund’s short liability position is actually delevering and decreasing risk. “The powerful thing about overlay,” he said, “is that it is leverage from a narrow, asset-only perspective, but from an asset/liability bent it is risk reducing.”