Conventional de-risking involvesselling equities and buying bonds but there are alternativestrategies to consider to reduce pension risk, especially for plansthat still need equity returns to close their funding gap. (Photo:Shutterstock)

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Many investors will be familiar with the concept of buying putoptions to hedge exposure to the equity markets: An investor pays apremium to buy the option to sell equities at a specified level(such as 10% below the current level) at a future date — such as inone year).

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Investors may also have the view that using options to hedgeequity exposure is costly and complex and that more traditionalde-risking strategies, such as selling equities to buy bonds, arebetter.

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This perception may not be valid, especially if some thought isgiven to how a hedging program is constructed and how to compare itagainst traditional strategies.

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Many long-term investors, such as pension plans, should not needto completely hedge their equity portfolios, which is what you getwhen you buy a traditional put option. If only partial protectionis needed, then a hedging strategy can be implemented in astraightforward and cost efficient way.

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For example, it is possible to buy protection against a fall inthe S&P 500 over a three year horizon that starts 5% below thecurrent level (so a 95% strike price) and ends 25% below thecurrent level for a premium of about 3.6%, or about 1.2% peryear.

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A conventional three year put option that provides protectionfrom -5% all the way to zero would cost about 9%, or about 3% peryear. The conventional put would outperform the modified put (orput spread) only in scenarios where equities are lower by more thanabout 30% in three years' time, which looks quite expensive unlessone is very bearish on the markets.

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In addition, premiums for partial equity protection havedeclined significantly in recent years (see chart below). Premiumspaid for options can be compared with the potential returns thatwould be given up for alternative de-risking strategies, such asselling equities and buying bonds.

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Many investors believe that equities have a 4%+ per yearexpected return advantage over bonds.

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Assume an investor currently has $100m invested 60% in equitiesand 40% in bonds, and that she agrees that equities have 4%expected return advantage (7% vs. 3%, total 5.4%). The investor isconcerned about market risk over the medium-term.

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She can a) buy a 3-year put option protecting against equitymarket falls between -5% and -25% for 3.6% (about 1.2% per year) on60% of the portfolio. Alternatively, b) she can re-allocate theportfolio to 40% equities / 60% bonds. In a), the expected returndrops to 4.7% and in b) it drops to 4.6%. Either strategy willoutperform the current one if equity markets fall, and both willunderperform if they rise.

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For scenarios where equity markets fall more than about 13%(about -4.5% p.a.) or rise more than about 11% (about 3% p.a.) overthree years, then a) will outperform b).

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Also, in extreme equity market falls of more than about 40%,then b) will outperform a) again. Using options has allowed theinvestor to hold more in equities than she otherwise might havegiven a desire to reduce risk, allowing for more upside potentialif market conditions improve.

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Rather than paying premium, an investor can trade potentialfuture upside returns for downside protection. For example,corporate defined benefit pension plans that are reasonablywell-funded may only need limited returns from equities to reachtheir funding objectives.

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Due to IRS rules, pension risk is highly asymmetric: anadditional $1 in surplus past full funding is worth only about$0.30 after tax, while every $1 increase in deficit is worth about$0.79 after tax. A plan sponsor who wishes to reduce downside riskcan trade off upside potential that would likely only result inunneeded surplus.

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To afford the same -5% to -25% protection over three years asabove, the investor would need to sell potential equity priceappreciation above 26%. The level at which upside would need to besold to fully finance downside protection has also increasedrecently, making this kind of strategy relatively more attractive(see chart below).

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For some plan sponsors, a +26% total return on equity marketsover three years would already give them all the excess return theyneed – the prospect of “giving up” additional return on top of thatseems like a small price to pay for protection from the first 25%of losses.

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In summary, with a simple, transparent strategy it is possibleto provide meaningful equity market protection without removingequity exposure entirely.

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Such strategies are not too good to be true. Paying a premiumfor protection will be a drag on returns if markets do not fall,and similarly, forgoing potential upside will causeunderperformance if equity markets rise significantly.

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However, many investors may be surprised at the current costs ofdownside protection and may consider this a worthwhile tradeoff.

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Frequently asked questions

Equity options, which are a form of derivative contract,can move in my favor or against me. If it moves in my favor, how doI know I will be paid what I am owed?

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The risk expressed in this question is counterparty risk.Derivative contracts are either entered into on an exchange(exchange-traded contracts) or directly with a counterparty(over-the-counter contracts), generally a large investmentbank.

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In both cases, derivatives used by institutional investors arefully collateralized. This means that if Counterparty A owesCounterparty B $1m on an open derivatives contract, Counterparty Amust also set aside (or “post”) $1m in collateral to Counterparty B(or to an exchange if an exchange-traded derivative).

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This collateral generally needs to be cash or Treasuries or anequivalent, very conservative, asset. The value of the derivativecontract is updated every day and the collateral value must beupdated daily as well.

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In this example, if Counterparty A were to fail to payCounterparty B when the derivative contract is closed or matures,then Counterparty B would be able to keep the collateral that wasposted to it to cover what is owed, thus offsetting most or all ofany potential loss.

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Prior to the 2008/09 Great Financial Crisis it was much morecommon for derivatives positions to be either uncollateralizedentirely, for much less conservative collateral to be used, or forcollateral to be re-valued and moved much less frequently.

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When large financial institutions went insolvent, many morecounterparties were left with unsecured claims, than would be thecase today. Regulatory changes since the Great Financial Crisishave materially reduced this risk.

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I hear that derivatives are expensive. How much doderivatives cost?

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Investments generally have two sorts of costs associated withthem: bid/offer spreads to trade them and fees paid to aninvestment firm to manage them.

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Derivative contracts have a bid/offer spread just like any otherfinancial instrument like a stock or bond. These spreads can bewider or tighter than physical securities depending on the marketand type of derivative.

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Management fees for derivative positions used for riskmanagement or to create a synthetic position, as opposed to usingderivatives to seek “alpha,” are generallyinexpensive, with fees comparable to what are paid for passiveindex management.

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In addition, some derivative positions require premiums to bepaid, which some mistakenly see as a source of expense. A premiumpaid to enter into a position is akin to buying a stock or bond,with initial value of the derivative equal to the premium paid.

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If the position is closed out immediately, then the premium isreturned, less any bid/offer costs. The premium also shows up as aportion of the derivative contract value on a custody statement –it is not “lost.”

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If premiums are paid continuously, such as for a program tohedge equity risk, then this will feel like buying insurance andthe cost could seem expensive. But that is quite different to therebeing an excessive cost to transact derivatives themselves.

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Are derivatives contracts liquid? Am I locked in for aperiod of time?

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Derivatives contracts referencing major equity markets, asdescribed in the examples above, are liquid and can typically beclosed out at any time.

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A contract may have a 'term' of several months running toseveral years, meaning that the derivative is contractuallyproviding a certain return over that period.

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However, the investor is not locked in to holding the contractover this term. It is possible to exit the contract, with themarket value of the derivative being realized at that time.

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This is very much akin to selling a bond to another investor,without actually holding the bonds the full term which could beyears or decades away.

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How widely are derivatives used within pensionplans?

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Currently, derivatives are often directly held by large USpension plans, with adoption relatively low among small pensionplans. However, it is a common misconception that derivatives arereserved for only the very largest plans (>$1 bn) asimplementation of equity and interest rate derivatives isrelatively straight forward.

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That said, there is some additional operational complexity andstakeholder education required when holding derivatives directly,which has meant that take-up by plans under ~$50m, has beenlow.

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It is also common for both equity and bond mutual funds, held bypension plans, to use derivatives for risk management purposes. Inthis case derivatives are held within a fund, and not directly bythe plan, and so plans may not be cognizant of the fact they areindirectly holding derivatives.

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Outside of the US, it is much more common for pension plans tohold derivatives. In the UK, for example, around 70% of plans useinterest rate derivatives to manage risk and around 25% haveconsidered using equity derivatives (about 10% have actuallyimplemented these strategies).

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James Walton is an Investment Director inRiver and Mercantile Solutions' Boston office. Jamesworks with clients on financial risk management, developsinvestment strategies and derivative solutions. He also leads thedue diligence of annuity providers and is a member of the USInvestment Committee. [email protected]

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Ryan McGlothlin is a Managing Director in Riverand Mercantile Solutions' Boston office. Ryan works with clients oninvestment strategies and financial risk management. He is a memberof the Global and US Investment Committees. [email protected]

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