(October 17, 2011) — While there is still a general concern among institutional investors about effectively using derivatives, schemes are increasingly using these investment vehicles to hedge against interest-rate risk.

“We’ve seen a growing number of especially corporate pensions using derivatives as they pursue liability-driven investment,” Strategic Investment Solutions’ Managing Director John Meier told aiCIO. “If you’re trying to lower pension surplus interest rate risk, using derivatives is definitely effective in order to maintain a reasonable level of return.”

Mercer consultant Gordon Fletcher voiced a similar perspective, noting that he has witnessed a much greater interest in derivatives among corporate funds as they look into derisking strategies amid an environment of frozen legacy liabilities.

The perceived growing use of derivatives among institutional investors is supported by a June study that showed that asset owners have retained an appetite for innovation where specific principles are met, fueled by the entrepreneurial culture in the United States. The annual, independent study by CREATE-Research, commissioned by Citi’s Global Transaction Services and Principal Global Investors, revealed that schemes have welcomed new asset allocation techniques, such as the use of derivatives, to hedge out unrewarded risks. However, leverage, structured products, portable alpha, and currency funds were perceived as lacking intrinsic value.

Despite the greater use of derivatives, Meier added: “In the US and elsewhere, I think there’s a general concern over derivatives, but if there’s adequate education about what they do and how they work, schemes can get trustees to sign on,” adding that many funds are still hesitant about the extra risks that derivatives introduce, such as basis risk — when the derivatives used to hedge don’t directly hedge with what they’re trying to hedge — and counterparty risk.

Consultants note that with derivative usage comes big challenges in terms of governance. “Investment committees meet once a quarter — they may not have much time to allocate to running a plan, and using derivatives is quite a big commitment,” Fletcher noted.

UK Pensions Mirror America — or Vice Versa? 

UK-based advisers have reiterated a similar perspective of distrust over the use of derivatives, as reported by Reuters. “When the world is concerned about deflation, that is the time for a pension fund to start thinking about inflation risk. Right now, the cost of hedging that over 10 years using inflation-linked government bonds is less than the government target (for inflation),” Shalin Bhagwan, head of structuring in the Liability Driven Investment Funds unit at Legal & General Investment Management, told Reuters, noting that schemes are running out of time to hedge portfolios against inflation.

Schemes in the US and the UK aren’t widely using derivatives to effectively hedge against inflation risk, but they could be, Meier told aiCIO. “Inflation risk is a risk that institutional investors are increasingly focused on. With the markets reflecting an expectation that inflation will remain at current levels, the cost for hedging now is pretty low. This could be a good time to hedge against inflation and especially though the effective use of derivatives.”

In terms of longevity risk, Meier said that while derivatives haven’t been widely and effectively used to hedge against this type of risk, there may be opportunity for derivatives in that area of risk management. While still in its infancy stage, Mercer’s Fletcher added that UK schemes are ahead of the US in terms of using derivatives to hedge against longevity risk. “It’s certainly on the table in the future for both the US and UK,” he said.

In May, Bloomberg reported that banks are now forming death derivatives to help pension funds better manage longevity issues. According to the news service, pensions are purchasing insurance against the risk of their members living for longer than anticipated. Yet, it has become increasingly difficult to find buyers willing to take that risk, packaged in the form of bonds and other securities. JPMorgan and Prudential have set up a trade group to establish a secondary market for longevity risk, while Goldman Sachs and Deutsche Bank have created insurance companies that promise to pay pensions if retirees live beyond a certain age, Bloomberg reported.

Meanwhile, schemes are increasingly transferring risk to insurance companies, driven by merger and acquisition activity, a growing number of closures and part-closures of defined benefit pension schemes, and concerns over longevity risk. A March report by Hymans Robertson showed that UK pension buyouts, in which an entire scheme is passed to a specialist insurer, are becoming more and more prevalent.