UK - Pension scheme trustees could reduce the risk of massive equity falls by using derivatives to limit their losses, a risk management specialist claims.
Delegates at the 'Changing rules, changing tools' conference heard that companies are currently being hit by a double whammy of poor profits and increasing pension scheme contributions – a position that has caused tension between the pension scheme and its sponsoring company.
Derivatives - or options - could guarantee that the equity component of pension funds will never slip below a certain level in return for the small cost of the option.
Cardano Risk Management managing director Theo Kocken said: “By using options you will have slightly less if the markets perform really well but will eliminate the chances of extreme risks in equity markets.”
Baker & McKenzie pensions lawyer Clifford Sims warned trustees that they would have to check their scheme’s trust rules to make sure that they have the authority to write options and derivatives as some schemes do not allow these moves.
He added that there would also be tax issues as the Inland Revenue has strict rules on investment in these products.
Many pension managers and scheme trustees still have bad memories of portfolio insurance in the 1980s when many policies failed to deliver when equity markets plummeted. Kocken said the credit risk involved in buying an option was much reduced as most trades were fully backed by collateral. He also emphasised that options were completely different from using portfolio insurance.
Asset liability modelling company Ortec Consultants' Guus Boender said: “When trustees are shown the effect of a few years of poor investment returns and compare it with an optioned scheme they will be able to see and understand the positive effects of this strategy.”
Other firms thought that hedge funds would be more appropriate for reducing risk in pension schemes even though they do not perform as well if used as a simple investment.
Zanders & Partners manager Rogier de Barbanson said: “Investing in hedge funds can increase efficiency when viewed in portfolio context and not in stand-alone investment context.”
By Jonathan Stapleton
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