Pension Funds to Drop Derivatives? | Chief Investment Officer

(February 10, 2012) — High fees and complex counterparty structures may drive institutional investors away from using derivatives new research has suggested, as regulators finally agree the terms on how to legislate practices in Europe.

Reaction to the near-collapse of the banking crisis has meant the way these instruments are used by pension schemes and other large investors has changed, investment consulting firm Towers Watson has said.

In a paper entitled ‘Is this the end of OTC derivatives for pension schemes?’ Towers Watson lays out how changes in regulation and market attitude to these investment tools will make it more costly and complicated for investors to use them.

The paper said that underlying terms in documentation had already become less attractive for investors.

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It said: “Flexibility over which assets can be used as eligible collateral has also reduced significantly. It appears that counterparty banks are less willing, or able, to accommodate pension schemes. This stems from a reduction in banks’ risk appetites and changes in their regulation.”

Yesterday, the European Market Infrastructure Regulation (EMIR), a new regulatory framework for over-the-counter derivatives based on criteria set by the G20, was approved by the European Parliament and the Council of the European Union, as reported in aiCIO’s sister publication The Trade.

The regulation will enable standardised derivatives to be traded on exchange-like trading venues, cleared through central counterparties (CCP) governed by strict organisational, business conduct and prudential requirements, and traded on central reporting repositories.

Some of the most widely used derivative structures used by pension schemes, such as inflation and longevity swaps, do not yet fall under the new regulation but it still may close the door for large investors, the Towers Watson paper said.

“OTC derivatives which will not be subject to mandatory central clearing are likely to require banks to hold more capital than previously has been the case. This will result in higher costs for banks which we would expect to be passed to customers, thus increasing the costs of transaction OTC derivatives that are not centrally cleared.”

The paper concludes that increased costs for investors should be unnecessary, but may still happen.

It also notes that banking counterparties were increasingly only taking short-dated, high quality government bonds as collateral or cash – Towers Watson feared that they would eventually only take cash, which would mean investors would have to hold large sums of this non-return-seeking asset for their derivatives use.

“In addition, the UK’s Independent Commission on Banking has indicated that the derivative activities of UK banks should largely be in the non-ring fenced part of the bank – that is, the casino.”

However, the paper assets that pension funds, and other liability-driven investors, need to carefully examine the benefits of using derivatives, both OTC and cleared through a CCP, as they were of significant importance to risk management techniques.

As high volatility pummels institutional investor portfolios, investors are increasingly seeking “global listed infrastructure” strategies for their Liability Driven Investing (LDI) framework.

(February 9, 2012) — Institutional investors are moving beyond traditional equity and fixed-income by implementing “global listed infrastructure” strategies into their Liability Driven Investing (LDI) framework, according to a newly published report by Capital Innovations, an alternatives-focused investment manager.

“Investors are faced with a challenging landscape with low GDP growth, high volatility global equity markets and a low interest rate environment that has spanned several decades,” said Michael Underhill, Chief Investment Officer of Capital Innovations. “Purchasing power has been eroded by 80+% in the last forty years,” he said, noting that investors are eager for long-term investment programs.

Consequently, according to Underhill, Liability-driven Investment strategies have proven effective in factoring an investor’s liabilities as an essential element of determining asset allocation, thereby helping to more efficiently manage risk.

According to Underhill, LDI strategies are useful for an array of institutional investors, including corporate retirement programs, sovereign wealth funds, and endowments and foundations. While numerous corporate pension funds have been blindsided by market volatility, now struggling to focus on an asset allocation that is appropriate for their funding status, endowments and foundations are struggling to gain inflation protection for their portfolios, Underhill said.

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“All of these types of programs have found global real assets attractive in an LDI framework for their ability to provide for their portfolio,” Underhill said.

Underhill’s remarks on the growing propensity of long-term investors to move beyond traditional equity and fixed-income and focus on infrastructure follows a report last year by the World Economic Forum (WEF), which reported on the future of long-term investing. In the report, headed by 19 major pension and private investment funds, the WEF warned that policy and investor changes are instrumental in driving the growth of long-term investments.

According to Max von Bismarck, director and head of investors of the WEF and co-author of the report, long-term investors are crucial for the global economy, acting as counter-cyclical forces in markets during times of high volatility, solving decaying infrastructure problems around the world.

See aiCIO’s Liability-Driven Investing Special Issue here.