Pension funds cautiously explore hedges

Risk, according to Warren Buffett, "comes from not knowing what you are doing". It is no wonder then that the pension fund community, which has long been a proponent of plain vanilla equity and bond investing, finds the structured product market risky.

"Demand has always typically been low for structured asset-type products, other than in asset classes such as commodities," says Nigel Cresswell, a former executive director at Lehman Brothers Pensions Advisory Service, whose job it was to sell structured products to pension funds. "Investors are shy about using them and don't understand them. They can't fully assess the risk profiles."

But that is not to say pension funds have turned their backs on structured products completely. According to a recent article in the Financial Times, demand for over-the-counter type structures, such as inflation or interest rate swaps, is on the rise.

Data from Watson Wyatt, for example, find that the firm advised on some £15bn (€19bn, $30bn) worth of over-the-counter transactions for UK pension funds last year - up from £13.7bn in 2006 and £7bn in 2005.

The firm's senior investment consultant, Nick Horsfall, says: "This is as a result of a broad realisation that derivative instruments can provide pension funds with protection, enhanced performance and a better match for liabilities." In this increasingly risky investment environment, he adds, "the interest rate and inflation swaps used by our clients have proved their worth in managing deficit risk".

Mr Cresswell agrees: "Using inflation or interest rate linked swaps to hedge out unrewarded risks can be a no-brainer. A very long-term investor, such as the Finnish Church, might not need to worry about short-term fluctuations but a Dax 30 or FTSE 100 pension fund sponsor could face wild movements within its balance sheet as a result of interest rate changes, which might result in them, for example, being downgraded. For those guys, these hedging type of structures are crucial."

Inflation-linked structures are of particular interest to UK schemes, which have to peg payouts to the retail price index, while in continental Europe, particularly the Netherlands and Denmark, interest rate derivatives are the structure of choice.

"In countries where the regulator has asked pension funds to mark their liabilities to current market values instead of using a fixed rate, such as in Denmark and the Netherlands, you find those schemes turning to interest rate hedges," says Mr Cresswell.

Mercer, a pension consultancy firm, adds: "Corporate sponsors are realising that interest rate risk is something they want to manage. How they go about that, however, differs."

Mr Horsfall agrees: "Swap solutions are only one option, but they are not suitable for every fund and we have been advisers in many cases where such transactions are not supported. Implementation of liability-driven investment using derivatives usually requires significant additional governance resources, whereas using bonds can often be effective regardless of governance capabilities."

Post credit crunch, however, pension funds have had to think very carefully about structured solutions. With the solvency of some banking groups being thrown into doubt and counterparty risk increasing, investors have become more cautious than ever before about the sector.

"Since the problem with Bear Stearns it is no longer inconceivable that the third party used for these transactions - whether they are for hedging or asset-seeking purposes - won't go belly up," says an official at a European investment bank. "There was once a perception that any dealings with an investment bank were virtually risk free but that notion has disappeared and pension funds are working hard to make sure their counterparty risk is in check."

Indeed, Watson Wyatt says the credit crisis has delayed the execution of derivatives-based liability hedging strategies. The firm says that the International Swaps and Derivatives Association agreements and documentation required to execute such transactions are now taking longer to process because they contain more onerous legal conditions.

Talking about asset-generating structures, Russell Masding, senior investment consultant at the firm, says: "Investors just don't understand how to assess the risk they are facing and the rating agencies have done a very bad job of assisting them".

In fact, just two months ago the President's Working Group on Financial Markets in the US, headed by Henry Paulson, Treasury secretary, warned investors against relying solely on credit agency ratings of securitised assets, while calling for changes in ratings agency practices. The group is to also press the private sector to develop disclosure standards for investments in securitised credits, including asset-backed securities and collateralised debt obligations of ABS.

"This is no surprise," says Mr Masding, "there has long been a feeling out there among investors that the advice they were getting from rating agencies could not be trusted."

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