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The largest pension plans have been using leverage and derivatives to manage asset liability risk for decades. Technology, experience, and increasing familiarity have brought the use of leverage and derivatives to the mainstream.
The largest pension plans have been using leverage and derivatives to manage asset liability risk for decades. Technology, experience, and increasing familiarity have brought the use of leverage and derivatives to the mainstream. Over the past 5 years, we’ve seen an increasing interest in these strategies from clients of all shapes and sizes for managing pension plan risk.
For pension plans that are beginning to explore the world of leverage and derivatives, this article will discuss:
In a future article, we will try to answer:
Leverage refers to having exposure to an asset class without fully owning the asset. This is achieved using either borrowed capital or financial instruments.
Derivatives are financial contracts that derive their value from an underlying financial asset. Pension plans can purchase these contracts to gain exposure to the underlying asset. For example, a pension plan that wants to gain interest rate exposure can purchase a contract to buy a bond at a fixed price in the future. By buying this contract, the pension plan gains exposure to the returns on the bond without purchasing the bond outright.
The terms leverage and derivatives are sometimes used interchangeably. However, not all leverage is achieved through the use of derivatives. For example, repurchase agreements allow a pension plan to use leverage. We will refer to the broader concept of leverage unless specific reference to the use of derivatives is appropriate.
Why do pension plans use leverage?
There are three common reasons.
1. Hedging asset liability risk - The most common reason we have seen pension plans use leverage is to manage asset liability risk. For example:
Underfunded plans can benefit from using leverage to manage asset liability risks while maintaining exposure to return-seeking assets to help fund their deficit. For example, equity futures and options can be used to maintain exposure to return seeking asset classes, while freeing up physical assets to be used to reduce asset liability risk.
2. Enhancing returns - Leverage can help pension plans:
In the fixed income world, return enhancing leverage is commonly used in private credit investments where managers will often offer a levered option to their funds. This allows plans to increase their exposure to these assets. The low interest rate environment of the last few decades has been favourable to these strategies.
3. Portfolio flexibility - Trading physical assets can sometimes be difficult or impractical due to transaction costs or liquidity challenges. In these cases, pension plans can quickly dial up or down their exposures using derivatives. The high liquidity of derivatives allows pension plans to quickly adjust their exposure, providing additional time to unwind physical assets, and saving on transaction costs.
In our experience, the most common use of derivatives for pension plans is for risk management.
Pension plans typically use leverage to manage four types of asset liability risk: interest rate, inflation, currency, and equity.
Interest rate risk – Pension plan liabilities are exposed to changes interest rates. Unless the plan’s assets have a similar exposure, the plan’s funded status will also fluctuate due to changes in interest rates. Using leverage in an interest rate risk management strategy is a natural starting point for many pension plans and is the most common form of leverage we implement for our clients.
The case study is for illustrative purposes only and does not represent an existing client portfolio.
Inflation risk – Plans that provide increases in benefits based on changes in CPI are referred to as “indexed” plans. These plans are exposed to the risk of inflation being higher than expected. Traditionally, this risk has been best hedged using inflation-linked securities, such as real return bonds. However, these securities are typically issued by the federal government, and therefore provide a lower yield than provincial and corporate bonds.1 This lower yield causes many indexed pension plans to not hedge their inflation risk.
By using leverage, a pension plan can overlay the inflation protection of real return bonds onto a nominal fixed income portfolio. They can also overlay corporate credit spreads onto a real return bond portfolio.
The case study is for illustrative purposes only and does not represent an existing client portfolio.
Currency risk – Many pension plans invest abroad to diversify their portfolio and to access asset classes or markets that might not be available in their home country. This leaves pension plans exposed to movements in currency, which can be a bigger contributor to portfolio volatility than the underlying asset class. Canadian pension plans in particular use foreign markets since local fixed income and equity markets are highly concentrated. For these plans, derivatives offer a way to maintain these foreign exposures without incurring currency risk.
For return seeking assets or short dated fixed income assets with little duration, currency forwards provide a simple and effective way to hedge currency risk at a relatively low cost. For mid-to-long dated fixed income assets, cross currency swaps provide an effective way to hedge both currency risk and foreign interest rate risk, while adding potential yield due to the swap spread differential between the U.S. and Canada. For more information on this potential yield pickup, please refer to the article “Corporate bonds – are you missing an opportunity?”
Equity risk – Pension plans typically rely on their equity allocation to provide higher expected returns as a means for paying for accruals or for funding deficits. However, these higher expected returns come with higher return volatility. Pension plans can offset their downside exposure to equity markets using derivatives.
For the most certain downside protection, put options give pension plans the option to sell equity at a fixed price, providing protection if the value of equity falls below that price. This approach can be expensive as the pension plan pays a premium for this option. To save on costs, plans can supplement this approach by selling equity futures calibrated to provide similar downside payoff, or by dynamically purchasing treasury futures during times of high uncertainty. Purchasing treasury futures would allow pension plans to take advantage of the high correlation between negative equity returns and rate declines. The dynamic approach allows plans to save on premium costs, and equity and treasury futures tend to be better priced than equity puts during market risk-off periods.
Leverage and derivatives are powerful and accessible tools for pension plans. Risk management is a great place for plans to start their journey and the resulting impacts can be seen almost immediately. Leverage can help pension plans manage a variety of common asset liability risks. We encourage pension plans to work with their investment managers and consulting partners to determine whether these types of strategies could help them achieve their long-term objectives.
1 FTSE Canada
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