Pension funds’ hedging dilemma

March 30, 2012

Pension funds have no shortage of concerns: their funding deficits are rapidly growing in the current low-return environment, and ageing populations are stretching their liabilities.

But a recent survey of pension funds trustees by French business school EDHEC has found that their biggest worry, cited by nearly 77% of the respondents, is the risk that their sponsor — the entity or employer that administers the  pension plan for employees — could go bust. Yet 84% of respondents fail to manage the sponsor risk.

So how do you hedge against such a risk?

You could buy credit default swaps of the sponsor company or buy out-of-the-money equity put derivatives to seek protection. But both options are costly and illiquid. Moreover, it might send a negative signal to the market: after all, if the company’s pension fund is seen effectively shorting the company in an aggressive manner, investors may wonder “What do they know that we don’t?”

Erwan Boscher, head of Liability-Driven Investing and Fiduciary Management at AXA Investment Managers, says:

“Using market instruments like CDS and out of the money equity puts were suggested as a way of hedging sponsor risks, but we seldom see them implemented because of the cost, liquidity or reputational risks for the sponsor.”

Alternatively, the pension fund could diversify assets away from the sponsor’s core business by buying assets that are uncorrelated with the sponsor’s sector.

Boscher, speaking at an EDHEC conference in London earlier this week, says taking out insurance is becoming more popular.

“Now that insurance solutions are developing so we could see more creative solutions implemented.”

Sally Bridgeland, CEO of BP Pension Trustees Limited, says it is crucial to differentiate various type of risks.

“We do pay premium to lay off sponsor risks… but we differentiate a low probability and high impact event from a high probability event hat has a moderate impact… Stress-testing your portfolio is important.”

She said capital and income impairment risks are also a major risk for the BP fund as it has a high bias towards equities.

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