Pension Plans Find Comfortable Uses For Derivative

by Laurie Kaplan

Pension plan boards of directors are notoriously wary of derivatives. Not fully versed in the mechanics of these often baffling, powerful tools and wary of the inherent leverage, many boards have opted to overlook the significant benefits these instruments can bring to the portfolio management process. "The cost of a hedging program gone awry is simply too great," says a spokesperson for one pension plan sponsor. "We don't use derivatives at all."

That plan sponsor is hardly the only U.S. institutional investor to ban the use of derivatives. However, it is gradually becoming the exception rather than the rule. Despite valid concerns about leverage, potentially poor liquidity, and sometimes questionable pricing practices, pension plan sponsors are increasingly giving a green light, allowing both their internal and external money managers to use derivatives. Moreover, "while many pension plans claim not to use derivatives, they have a lot of money farmed out to external managers who do use them," says a consultant.

According to George Oberhaufer, a pension plan consultant with the Frank Russell Company in Tacoma, Washington, a significant percentage of U.S. pension plans now use futures, forwards, and options contracts to hedge foreign currency exposures and to synthetically invest cash balances.

Futures & Forwards, Please. Hold the Options

The $15.8 billion Tennessee Consolidated Retirement System is a case in point. It uses S&P 500 futures to keep the plan's asset allocation in line with its benchmark. "The goal is to allow the portfolio managers to concentrate on picking stocks and to not worry about marketing timing," says Roy Wellington, international portfolio manager for the Tennessee pension plan.

The Tennessee plan sponsor also uses currency forward contracts to manage the plan's foreign currency risk. "We view foreign currencies as a separate asset class," says Wellington. "We use forward contracts to add value to the fund over a market cycle." The plan hedges its foreign currency exposure only when it anticipates a period of U.S. dollar strength. In a weak dollar period, it stays largely unhedged.

Tennessee uses only futures and forward contracts. Its board of directors declined to approve the use of options. "The Board wants a plain vanilla program whose risks are easily understood," Wellington explains.

Another rather moderate user of derivative instruments is the $900 million pension plan of Asea Brown Bovari (ABB). It began using foreign currency futures and forward contracts about five years ago to hedge its $140 million international equity portfolio against adverse foreign currency movements. A year later, it began using S&P 500 futures to obtain equity exposure on cash balances.

In implementing derivatives strategies, ABB's internal and external managers are careful to use straightforward, highly liquid instruments, such as the S&P 500 futures contract. The sponsor also avoids leverage at all costs. "Most of the risk associated with derivatives stems from the creation of leverage and the use of overly complex products," says Larry Morganthal, manager of retirement plans for the Stanford, Connecticut-based U.S. subsidiary. "All of the derivatives-related disasters that have made headlines in recent years have been due to the use of poorly understood products and too much leverage," he says. ABB combats this problem by using only plain vanilla instruments and by performing careful sensitivity analysis over a range of interest rate scenarios. "It is very important to understand exactly how the instruments are going to react under different market conditions," Morganthal explains.

ABB's currency overlay program is run by London-based Paredo Partners. The firm is known for its use of option-like hedges designed to protect the portfolio from adverse currency movements while simultaneously allowing it to benefit from favorable exchange rate shifts. The key to the strategy is in the use of synthetic options created with futures contracts, in lieu of actual option contracts, which eliminates the high, upfront cost of options. Morganthal estimates that the strategy has enhanced the pension plan's total return by about 4.6 percentage points since it was first implemented in 1991.

Managed Futures

In addition to the aforementioned, low-risk derivatives strategies, which a growing number of pension plans are using to add incremental value, some pension plans, including San Diego County Employees Retirement System and The Illinois Teachers Retirement System, have taken the plunge into the world of managed futures. Here, too, the reality is a lot tamer than generally perceived. One of the key reasons for allocating assets to a managed futures account is the potential for reduced risk which is associated with the historically low correlation of returns between managed futures and other asset classes. For example, the correlation of returns between a futures investment and the S&P 500 for the 10 years ended December 31, 1993, is -0.6 percent, according to Mount Lucas Management.

According to Greenwich Associates, approximately 13 percent of U.S. pension plans with total assets of more than $1 billion have a managed futures program. Most pension plans, however, continue to be put off by the managed futures industry's use of leverage. Illinois Teacher's Don Nesbit says his plan circumvents this pitfall by establishing strict guidelines on the use of leverage.

Nesbit stresses that the key to success in virtually all of the aforementioned derivatives strategies lies in maintaining appropriate levels of risk. "You have to have controls in place to make sure your managers are adhering to the guidelines," he says. The plan's guidelines are designed primarily to prevent the use of unwarranted leverage. "Our managers are limited to the amount of money they have under management," says Nesbit. "If we give a manager a $100 million allocation, he cannot use it to buy $200 million of exposure through futures."

Illinois Teacher's relies on its trustee to watch for the use of unnecessary leverage by performing ongoing sensitivity analysis of the portfolio under a variety of market conditions. "We are always careful to include the possibility of a low probability event. It is the only way to preclude a blow-up like Orange County," Nesbit says. "Nobody anticipated the magnitude of 1994's interest rate increase."

To the extent that the plan's managers work within the plan's guidelines, the plan encourages its managers to use derivatives. "We don't want to take tools away from them," says Nesbit. "Derivatives allow us to move quickly and efficiently."

Laurie Kaplan is a free-lance writer based in Chicago.

There is a substantial risk of loss trading futures, forex and options. Before investing please understand that changes in the cash and commodity futures price do not typically correlate on a one to one ratio with the corresponding commodity option price. Moreover, past trends in cash and futures prices on specific commodities do not necessarily forecast current profitability of options on those commodity futures. All known market news will not necessarily affect option prices since the news is usually already factored into the underlying futures price, as well as option value.