Derivatives – The star on top of the Christmas tree or just a stocking filler?

23 / 11 / 2022

Key Points

• In line with the Investment Regulations, Derivatives can be used only as a risk management tool or for efficient portfolio management.

• Trustees should always have their scheme’s statement of investment principles in mind when making investment strategy decisions.

• Trustees should consult with their advisers over the levels of derivative investments and whether any de-risking is required.

What are Derivatives?

Derivatives are essentially forward looking contracts in which the seller agrees to sell an asset on a future date at a price which is fixed at the time the contract is entered into (the “strike price”). Derivatives derive their value from an underlying asset which is determined at a future date. Commonly this asset is a currency, stock or bond but can also be in relation to interest rates or commodities.

For example, someone who agrees a strike price today to buy shares in a company which will be sold in two weeks’ time believes that in two weeks’ time they will have a valuable benefit if the shares go up in price. The contract therefore has inherent value based on how the underlying asset is performing and can be bought and sold before the contract ends.

Why do Pension Schemes invest in derivatives?

Defined benefit (“DB”) pension schemes are always looking for investment opportunities in order to improve their funding position in relation to their liabilities, usually in pursuit of the ultimate goal of a scheme buy-out with an insurer or self-sufficiency.

Derivatives are one such investment that DB pension schemes use to get a return on their investments. They can be used for efficient portfolio management or as a hedge in relation to the investment portfolio as a whole. They can be effective risk management tools.

What does the law say?

It is, of course, ultimately the members who must be at the forefront of trustees’ minds when choosing to invest in derivatives albeit the impact on DB employers of trustees’ investment strategy must also be considered. Trustees are under an obligation to act in the best interests of the scheme beneficiaries, which typically means their best financial interests. The Pensions Regulator (“TPR”) provides the following list of considerations which trustees must consider when adopting their investment strategy:

  • any limitations on investments contained in the trust deed and rules, and other legal requirements;
  • your fiduciary duty to choose investments that are in the best financial interests of the scheme members – for example, you must not let your ethical or political convictions get in the way of achieving the best returns for the scheme,
  • the suitability of different asset classes to meet the needs of the scheme and future liabilities;
  • the risks involved in different types of investment and the possible returns that may be achieved; and
  • appropriate diversification of the scheme’s investments – in other words not ‘putting all your eggs in one basket’.

It is accepted that pension schemes may invest in derivatives, but it is clear from TPR guidance that they should not be the sole investment vehicle and appropriate risk management structures or hedges should be in place. It is also worth reiterating that trustees should seek expert advice from professional advisers when setting their investment strategy. Trustees are ultimately responsible for the operation of the scheme, and therefore need to ensure they understand the investments they are making and any risk involved.

The UK implementation of the European Market Infrastructure Regulation (“UK EMIR”) sets the legal requirements for ‘over the counter’ (“OTC”) derivative investments and regulates the OTC derivatives markets. An OTC derivative is simply a derivative contract direct between two parties rather than taking place on a supervised exchange. Pension Schemes entering into OTC derivatives over a certain investment threshold are required to provide ‘margin’ (collateral). If a Pension Scheme’s derivatives exceed the relevant threshold, those transactions will need to be cleared by a ‘clearing house’ (“CCP”). The CCP effectively acts as the supervisor would on a regulated exchange. The CCP receives the margin and then stands in the middle of the contracting parties so that should one default, the CCP steps in so the contract may continue.

The aim of the UK EMIR was to increase transparency and reduce risk in the derivative markets by increasing reporting obligations and setting up safeguards such as CCPs. This was seen as of particular importance in the wake of the 2007/2008 financial crisis. There were initial concerns that pension funds may struggle to meet the clearing margin requirements as pension schemes do not usually hold large amounts of cash. Whilst these concerns did not immediately come to light, there was a stark reminder of the potential illiquidity of pension funds earlier this year where rapidly rising margin requirements triggered a mass sale of gilts and nearly lead to a collapse in certain DB pension schemes until the Bank of England stepped in.

Have some schemes gone too far?

As set out above, trustees must have certain statutory considerations in mind when setting their investment strategy. These statutory considerations include:

  • Investing scheme assets in the best interests of members and beneficiaries;
  • Ensure the security, quality, liquidity and profitability of the portfolio as a whole;
  • Invest predominantly in regulated markets;
  • Ensure assets are sufficiently diverse to manage risk;

and most notably in relation to derivatives, regulation 4(8) of the Investment Regulations states (paraphrasing):

  • Trustees may invest in derivatives but only to contribute to a reduction in risks OR to facilitate efficient portfolio management.

Also, such investments must “avoid excessive risk exposure to a single counterparty and to other derivative operations.”

Use of derivatives has become more and more common in pension scheme investment portfolios over the past 15 years, with an estimated two thirds of pension schemes invested in some form of derivative. Derivatives are now seemingly being used to the extent that may go beyond mere risk management or promoting efficient portfolio management. For a while, this seemed a ‘no-brainer’ approach for pension schemes with derivatives giving excellent returns and financial advisors saw them as a safe bet. The terms of derivative contracts may not have been as closely considered as they should have been e.g. whether in volatile markets the scheme would be able to meet large and sudden margin calls.

This has exposed pension schemes to much higher levels of risk than originally envisaged and as mentioned above was highlighted in an almost catastrophic way earlier this year when interest rate rises resulted in large increases in margin requirements for derivative investments, nearly causing a collapse in certain UK DB pension schemes.

Conclusion

Whilst derivative investment by DB pension schemes has become commonplace over the past 15 years, trustees should consider their exposure to the high risks they bring and whether their investment strategy reflects the required principles and statutory considerations.

Trustees should consult with their financial advisers and ask whether any de-risking of their portfolio is appropriate in light of recent events. In particular, trustees should discuss regulation 4(8) with their advisors and confirm their investments in derivatives are being used appropriately as risk management tools as required by the Investment Regulations.