In the world of corporate pensions, a consensus seems to be emerging about the endgame. Eventually, schemes will be taken off companies’ hands. As they are finally closed to new and existing members, they will be passed to an insurance company or the like.
Hence the appearance in the UK of a number of new contenders for this business, among them Goldman Sachs. The question is how they are to make money, given that the established insurers have been losing money on annuities for decades. Some of them aim to make better investment returns, mainly through the smarter use of derivatives. How might this work?
Begin with how derivatives are used by the established players. The crucial distinction is between rewarded and unrewarded risk. The first consists of risk you seek out to raise your return. The second is the risk posed by – for instance – interest rates and inflation, which you want to get rid of.
In the UK, at any rate, it is now pretty standard to do this with interest rate and inflation swaps (longevity risk is another matter, which we shall come to). The former are long-established. The latter involve an investment bank sniffing out streams of inflation-proofed revenue, say from a property company or utility. It will then offer its pension fund clients a swap between that revenue and the income on their conventional bonds.
The snag is that, as the UK pensions consultant John Ralfe points out, swaps rely wholly on existing capacity. They cannot create what was not there before, just re-allocate it.
This is the problem with longevity. Plenty of people want to sell longevity risk. No-one seems very keen to take it on. Eventually, we may see the emergence of a longevity index with enough liquidity to match buyers and sellers – but not yet. This matters, since longevity was the main reason the insurers lost so much money on annuities in the past.
Then we come to options. The UK retailer WH Smith created a stir last year by switching its entire pension fund into derivatives – mostly defensive, but with 6 per cent in long-dated equity call options. Call options give an investor the right to buy shares in future while put option provide a right to sell them.
W H Smith’s kind of strategy is more aggressive than it looks. Buying a 10-year call option on the FTSE 100 today will cost you a premium of 23 per cent up front. So the market has to rise by that amount for you to break even. Granted, you will typically have sold your equity portfolio and bought bonds, so you will get the higher income over the 10 years. But if equity dividends grow fast enough over the period, you might still have been better sticking with straight equities.
A much safer strategy is the collar, whereby you buy and sell matching puts and calls. That way you pay no premium, since the two cancel out. You also protect yourself against a market fall; but, of course, you also forego most of the benefit of a market rise.
And this, it turns out, is the point about derivative plays in general. Mostly they are defensive in character – a lowering of risk in exchange for lower returns. Either that, or they may not get you anything more than buying the underlying market.
This is essentially what financial theory would tell us. There is no free lunch; and if one kind of asset gives you a better long-run return than another, that is because they were wrongly priced at the outset. The investment banks might tell you different. But since they make a great deal of money on the more aggressive types of derivative, they are scarcely impartial.
For the new entrants into the pensions market, there is a further snag. It is pretty clear that they will have to operate under insurance regulations. These explicitly require that the more risky your investments, the more capital you have to put up.
This is the opposite of the conventional pension fund, which – historically, at least – was allowed to put less into the fund the more it was invested in risky assets such as equities. That turned out to be a nonsense and, if the rules are changed, so much the better.
None of this means the new entrants are unwelcome. On the contrary, they represent the future, at least in theory. But they have a tough job ahead of them. No doubt, they have various ingenious wheezes up their sleeves. But derivatives alone are not the answer.
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