Over recent years the use of over-the-counter (OTC) derivatives in the implementation of investment and risk management strategies for pension schemes has increased dramatically. In particular OTC derivatives have been a valuable tool in liability driven investment (LDI) strategies, allowing schemes to manage funding level risk with minimum disruption to the rest of the scheme’s assets.
It is therefore unsurprising that their rise in favour has mirrored that of liability-focused investment strategies, which have become increasingly popular over the past decade. This article begins by taking a closer look at OTC derivatives before exploring their current role within the pensions market and how this is expected to evolve in the future.
What Are OTC Derivatives?
OTC instruments are those for which the terms of sale are agreed between the individual parties on either side of the contract. Unlike exchange-traded instruments, the terms of the contract are flexible rather than standardised, and can be adapted to meet the individual needs and requirements of the parties involved. However, there are disadvantages to OTC securities: their customised nature often causes them to be less liquid than exchange-traded instruments, and because those that are not to be marked-to-market (unlike their exchange-traded counterparts) potentially suffer from counterparty risk.
Derivatives are financial instruments whose returns are linked to the performance of a reference variable. The range of variables which can be selected to underlie derivative instruments is extremely broad, encompassing individual securities, indices, and even non-tradable variables such as weather patterns or unemployment rates. Derivatives are useful in enabling investors to manage exposures for the purposes of hedging or speculation. Some common derivatives include swaps, which allow exposure to one underlying to be exchanged for another; forward contracts, which commit investors to pay (or receive) a specified price for something to be received (or sold) at a given point in the future; and options, which confer the right – but not the obligation – to ‘buy’ or ‘sell’ physical or synthetic exposures in the future.
A major advantage of derivatives instruments is that they tend to require little or no upfront investment – they are ‘capital efficient’. This gives trustees and sponsors greater control of their overall investment strategy and potentially allows schemes to hedge risk exposures without significantly reducing their allocation to asset classes with higher expected returns such as equities.
Using OTC Swaps to Maximise Capital Efficiency
The capital efficiency of derivatives allows the risk coverage provided by an LDI strategy to exceed the amount of cash held by the pension scheme.
By using OTC swaps to help hedge liability risks such as interest rate and inflation risk (rather than using physical instruments such as gilts), schemes are able to invest more money in growth assets with the aim of improving their funding level. This feature is particularly important in today’s market, given the large number of schemes currently experiencing funding level deficits, and the inability or unwillingness of companies to increase pension scheme contributions in the aftermath of the financial crisis.
How do Pension Schemes Access OTC Derivatives?
The method by which pension schemes access OTC derivatives is often linked to size and governance: larger schemes who have the appropriate governance structures in place tend to transact OTC derivatives in segregated mandates, while smaller schemes usually access such instruments through pooled funds.
In a segregated mandate, the pension scheme itself has ownership of the individual securities. In a pooled mandate, on the other hand, the scheme simply owns ‘units’ in a fund that contains the securities.
A segregated solution gives the opportunity to create a bespoke hedge which closely reflects a scheme’s estimated risk exposures, for example those associated with the scheme’s future pension liabilities. A pooled solution often uses a ‘bucket’ approach: one bucket may provide interest rate and inflation exposure in, for example, 10-year blocks. While this is less costly than the segregated approach, there is a partial loss of accuracy in terms of the closeness of the hedge, and this introduces some residual risk for the scheme.
How do Pension Schemes use OTC Derivatives?
There are three main ways in which pension schemes use OTC derivatives:
- To manage liability risks, such as inflation and interest rate risk, as part of an LDI strategy.
- Without knowing.
- To gain market exposure.
Manage Liability Risks
The ultimate objective of pension fund investing is to ensure that there are sufficient funds to pay the pension liabilities. LDI puts this objective at the heart of a fund’s investment strategy. A key aim of LDI is to manage funding level volatility (i.e. the variability of a fund’s assets compared to its liabilities). In practice this usually means using a range of tools, such as interest rate and inflation swaps, gilt total-return swaps, and gilt repos1, to construct an investment strategy that closely matches the nature of the liabilities. LDI assets are selected primarily for their matching qualities, rather than their ability to achieve high returns.
OTC derivatives used in the implementation of LDI strategies
- Interest rate and inflation swaps
In interest rate and inflation swaps schemes pay their counterparty a fixed rate and in return receive the actual rate of interest or inflation. Interest rate and inflation swaps change in value as future interest rate and inflation expectations change. Pension scheme liabilities also change with future interest rate and inflation expectations. If these types of swaps are held in the right amount the interest and inflation sensitivities of assets and liabilities can be matched.
Gilt total return swaps
Total return swaps (TRS) are contracts between two parties to exchange the return on two specified assets. One of the assets tends to be cash, while the other can be almost anything you like. Pension schemes often receive the return on a gilt to match the return of their gilt-based liabilities.
As with gilt total return swaps, gilt repos allow pension schemes to gain synthetic exposure to gilts to match their gilt-based liabilities.
Investment managers hired by pension schemes may use OTC derivatives for efficient portfolio management – for example to gain exposures to different markets while avoiding the transaction costs and other disadvantages associated with physical ownership. Fund managers may also use OTC derivatives to manage currency risk. The schemes themselves may not be explicitly aware of their fund manager’s use of OTC derivatives, beyond having approved the use of this strategy in their investment policy statement.
To Gain Market Exposure
Some pension schemes use physical exposures (such as gilts) to manage liability risks while using derivatives to obtain exposure to growth assets. This approach is sometimes called ‘upside down LDI’. The end result is often broadly the same – one difference is that it may be easier to hedge a scheme’s specific liability profile using derivatives rather than physical instruments and it is therefore more common for pension schemes to take this approach.
Current and Future Trends
Longevity risk is the risk that life expectancies improve more than is currently expected, increasing the value of future benefit payments and harming the scheme’s funded status. Improvements in medical care and living standards over recent decades have produced a trend of increasing life expectancies, making this risk particularly pertinent at this point in time.
Over the past few years a number of new and innovative techniques have evolved to allow pension schemes to address their growth asset risks and liability risks, some of which have been described above. Therefore, the contribution of longevity risk to a scheme’s total risk has become increasingly significant – making it the next target for reduction.
Recently, gilts have been yielding more than swaps. This has made investment in capital efficient gilt total return swaps and repos attractive for pension schemes. This trend should persist as long as gilt yields remain above equivalent swap yields.
Equity downside protection strategy
The recent volatility in the financial markets has led some investors to seek protection against extreme losses on their equity portfolios. One way of achieving this is by implementing a zero cost collar option strategy. By combining the purchase of a put option with the sale of a call option at a different, higher strike, the expense of obtaining downside protection is reduced (at the cost of sacrificing upside potential).
OTC derivatives play an important role in the management of the risk and market exposures of pension schemes. The growing popularity of hedging risks that have been previously overlooked, such as longevity risk and in equity downside protection strategies, means that the use of OTC derivatives by pension schemes looks like it is here to stay, and may well.
1A gilt repo is not strictly a derivative – although it is a synthetic instrument.
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