U.K. pension funds are gingerly turning to the over-the-counter derivatives market for a quick and easy way to reduce volatility and switch funds into fixed income, according to derivatives marketers in London. Among the most popular strategies, pension funds are selling out-of-the-money equity calls or entering total return swaps where the pension fund pays an equity index and receives a fixed income index, said Mark Versey, a structured derivatives salesman at Deutsche Bank.
One fund that is considering tapping the OTC market for the first time to reduce volatility is the Railways Pension Trustee Co. in London, which has GBP16 billion (USD23.3 billion) under management. Peter Murray, chief executive, said the fund would be interested in entering a low volatility strategy, such as purchasing a structured note which pays double-A rated corporate bond yields plus a spread. The fund is run on behalf of 100 employers and it is the chief financial officers of these companies that will have the final say on its financial strategy, he noted.
Barry Kenneth, derivatives marketer at Royal Bank of Scotland in London, said pension funds are turning to OTC derivatives to avoid moving the market by selling off cash equities and buying bonds. However, total-return swaps are the most popular because they give funds time to move out of cash equities and into cash fixed income, but give an instant synthetic exposure to fixed income.
Deutsche Bank's Versey attributes growing pension fund interest in the OTC market to a new accounting rule that calls for greater transparency in reporting. Financial Reporting Standard 17, which was introduced at the end of last year, requires pension managers to publish the surplus or deficit of their fund for the first time this summer. Allan Cook, technical director of the Accounting Standards Board in London, explained funds will have to start incorporating this information into their balance sheets from June 2003. As a result of taking a closer look at the potential volatility of their assets and liabilities, derivatives appear to be a more attractive alternative.
In addition, funds are preparing to meet the government's minimum funding requirement, which requires that pension fund's assets must equal at least 100% of their liabilities, noted RBS' Kenneth. Funds looking to prevent further erosion of value by switching out of equities are more likely to use derivatives to increase their fixed income exposure.
