UK : Surge in pension fund use of derivatives

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The use of derivatives by UK pension funds continues to grow rapidly, fuelling the inflation-linked market, which is expected to double in 2006, according to Watson Wyatt Investment Consulting. The size of the UK market in 2005 for end users (excluding intra-bank trades and executions with insurers) was estimated by a number of banks at around £9 billion (£3bn in 2004), but based on the size of inflation-linked swap executions already completed this year by the firm, the market could exceed £20 billion by year end*.

Nick Horsfall, senior investment consultant at Watson Wyatt, said: “There is a broad realisation among pension funds and their sponsors that there are a variety of derivative instruments that can provide pension funds with protection, enhanced performance and a better match for liabilities. In addition, they are realising that derivatives can alter the nature of that risk in ways that are not possible in the cash markets.”

In the UK, Watson Wyatt has advised on 60 over-the-counter derivative and related executions for Sterling-based institutions (19 since 1 January 2006), the total nominal exposure executed in those trades being some £30 billion (£4.6 billion since 1 January 2006). The majority of these executions involved interest-rate swaps, inflation swaps or related instruments.

Nick Horsfall said: “These structured solutions are certainly not for everyone and indeed we have advised many clients against the execution of inappropriate swap and other structured product transactions. Of key importance when considering these solutions, is that strategic advice should be entirely independent of any outcome and funds and their sponsors should not be beguiled by the ‘LDI-bandwagon’.

The main attractions for pension funds of using these strategies are that they can increase efficiency in the portfolio while also reducing risk. In addition, they increase pension funds’ choice of investment options because they achieve exposures that are not possible through the use of physical securities. While many structured products are not suitable for use by pension funds, there are applications for inflation-linked, interest rate and credit default swaps as well as equity options.

Nick Horsfall said: “Pension funds have some very important questions they need to answer before entering these strategies, including legality for use, pricing transparency in the product, whether the entity selling the solution has the appropriate product and can manage the collateral and will the product do what is expected of it.”

*The precise scale of activity is difficult to measure, since most deals are conducted privately between banks and pension funds.

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