Investment ManagementPension and BenefitsRisk Management

Walk Before You Run: Using Derivatives in Pension Funds

By November 3, 2020 No Comments

The value of educating stakeholders on why using derivatives can make sense.

During a recent NeuGroup for Pension and Benefits session sponsored by Insight Investment and BNY Mellon, a pair of members shared their knowledge and experience using derivatives in managing corporate pension plans. Two highlights:

  • Walk before you run” emerged as a key piece of advice to members, most of whom do not make extensive use of derivatives.
  • Educating stakeholders including finance committees, C-Suite executives and accountants on derivatives and their potential benefits is an essential step for companies walking toward using futures, swaps, options and other instruments.

Four levels. After hearing each of the pension group participants say if and how they use derivatives, NeuGroup’s Roger Heine categorized them in four groups:

  1. No use of derivatives. One member in this category said the pension plan at her company is not allowed to use derivatives but that she is interested to hear how people have managed what she described as a “big undertaking,” adding that the human capital needed is one key issue. Another member said his company does not use them, preferring the “physical approach” of using cash securities to rebalance, if necessary.
  2. Outside manager use. Several members allow external asset managers to use derivative overlays, for example, to help achieve liability-driven investing (LDI) targets.
  3. Dipping in their toes. These companies limit direct use of derivatives to specific situations, maintaining simplicity, straightforward controls and transparency. Examples include going long equity index futures against a cash position, maintaining both cash liquidity and equity exposure.
  4. Extensive use.  These corporates use derivatives to expand their opportunities to enhance returns around myriad risk limit parameters with more complex controls. They have generally arrived at this level incrementally over a number of years.

Benefits: strategic and tactical. One of the two members who uses derivatives extensively said his company uses them for strategic purposes, such as eliminating the need to move money physically between investment managers.

  • He and the other member also described using derivatives for tactical asset allocation to get exposure to an asset class. One said derivatives offer “the most liquid way to express our views; we can quickly change risk targets and allocations and achieve the goal of avoiding drawdown risk.”

Helping hands. One of the members described using third-party firms to monitor collateral for the company when it uses over-the-counter derivatives. That’s especially useful, he said, during periods of extreme volatility.

  • Another recommended that members getting their feet wet with derivatives use so-called completion account managers, who in some cases coordinate the steps necessary to implement a pension de-risking process.
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Justin Jones

Author Justin Jones

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