Pension Schemes Avoid Hedging Derivatives Despite Growing Funding Gap

(January 5, 2012) — Almost half of the largest pension plans in the United States are against using derivatives to hedge their liabilities or derisk their scheme through a buyout, despite reporting a rising level of deficits last year.

The aggregate level of pension scheme funding in the S&P1500 fell to 75% at the end of December, down from 81% a year earlier, according to investment consultant Mercer.

The company said that the aggregate deficit in pension plans sponsored by S&P 1500 listed firms reached $484 billion at December 31, 2011, an increase of $169 billion from year end 2010.

Despite this fall, Mercer reported that 48% of these schemes were ‘not likely’ to undertake a greater use of derivatives and financial instruments to hedge their liabilities in the next two years.

Some 42% said they were not likely to use an annuity contract or buyout deal to remove sections or all risk from their corporate balance sheet in the same timescale.

Some 20%, the highest number, said they would look to derisk their portfolio through asset allocation in the next 24 months.

Kevin Armant, Principal with Mercer’s Financial Strategy Group, said: “We see a growing number of pension plan sponsors seeking to reduce the effect of defined benefit pension volatility on their balance sheets and cash funding requirements…Dynamic asset allocation approaches that systematically reduce volatility as funded status improves are gaining traction, and many plan sponsors are engaged in detailed planning around the logistics of making lump-sum cashouts available to terminated participants as a means of reducing liabilities.”

Armant said the number of schemes seeking buyouts was growing, despite the relatively small number doing so at the moment.

The reluctance to use complex solutions to hedge liabilities has not been confined to the US. Mark Nicoll, Partner at consultant and actuary Lane Clark & Peacock (LCP) in the UK, told aiCIO: “Our experience has been that a number of UK pension fund trustees have resisted using derivatives as part of their investing strategy for hedging.”

Nicoll said trustees found some of the structures too difficult to cope with.

He added: “Derivatives can give you leveraged exposure, but investors will associate some of the difficulties in the financial crisis with complex financial products that include derivatives. I also expect the UK to have fared no better than the US in terms of funding levels. We don’t see any evidence that UK trustees will undertake greater use of derivatives at this time.”