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Leverage and derivatives, powerful tools for pension plans

April 13, 2022

Leverage and derivatives, powerful tools for pension plans

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. 

Leverage and derivatives, powerful tools for pension plans

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:

  • What is leverage, and what are derivatives?
  • Why do pension plans use leverage?
  • What are the common risk management strategies using leverage?

In a future article, we will try to answer:

  • What are the main risks of using leverage?
  • How can pension plans mitigate these risks?
  • What should pension plans look for in an asset manager that will implement leverage or derivatives strategies?
     

What is leverage, and what are derivatives?

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:

  • Interest rate and inflation mismatch risk can be hedged using repurchase agreements and other interest rate derivatives; and
  • Credit spread mismatch can be hedged with credit default or total return swaps.

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:

  • Increase exposure to return-seeking asset classes;
  • Transfer alpha from one asset class to another; or
  • Enhance return by investing in asset classes that are expected to earn more than the cost of borrowing.

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.
 

What are the common risk management strategies using leverage for pension plans?

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.

Repurchase agreements can be used to hedge interest rate risk beyond physical asset exposure.

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.

Real return bond and credit default swap index can be used to provide inflation-hedging characteristics and a corporate credit spread.

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.
 

Conclusion

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

This document is intended for Canadian institutional investors only. It is not for retail use or distribution to individual investors. The information in this document is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this document.

SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.

Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of September 30, 2020. Unless otherwise noted, all references to “$” are in CAD dollars.

This document may present materials or statements which reflect expectations or forecasts of future events. Such forward-looking statements are speculative in nature and may be subject to risks, uncertainties and assumptions and actual results which could differ significantly from the statements.

As such, do not place undue reliance upon such forward-looking statements. All opinions and commentary are subject to change without notice and are provided in good faith without legal responsibility. Past performance is not a guarantee of future results. All data is subject to change.

No part of this material may, without SLC Management’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.

© 2022, SLC Management

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SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate.

Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.

BentallGreenOak, InfraRed Capital Partners (InfraRed) and Crescent Capital Group (Crescent)  are also part of SLC Management.

Bentall Green Oak is a global real estate investment management advisor and a provider of real estate services. In the U.S., real estate mandates are offered by BentallGreenOak (U.S.) Limited Partnership, who is registered with the SEC as an investment adviser, or Sun Life Institutional Distributors (U.S.) LLC, an SEC registered broker-dealer and a member of the Financial Industry Regulatory Authority (“FINRA”) . In Canada, real estate mandates are offered by BentallGreenOak (Canada) Limited Partnership, BGO Capital (Canada) Inc. or Sun Life Capital Management (Canada) Inc. BGO Capital (Canada) Inc. is a Canadian registered portfolio manager and exempt market dealer and is registered as an investment fund manager in British Columbia, Ontario and Quebec.

InfraRed Capital Partners is an international investment manager focused on infrastructure. Operating worldwide, InfraRed manages equity capital in multiple private and listed funds, primarily for institutional investors across the globe. InfraRed Capital Partners Ltd. is authorized and regulated in the UK by the Financial Conduct Authority.

Crescent Capital Group is a global alternative credit investment asset manager registered with the U.S. Securities and Exchange Commission as an investment adviser. Crescent provides private credit financing (including senior, unitranche and junior debt) to middle-market companies in the U.S. and Europe, and invests in high-yield bonds and broadly syndicated loans.

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