By Mark Davies and Masroor Ahmad
As a car enthusiast, I can always find a tenuous driving analogy for anything. Nevertheless, when faced with the task of showcasing how derivatives should be implemented for pension schemes, drilling it down to brakes is an interesting way to demonstrate the complete picture.
On the face of it, brakes slow you down. They’re your safety net. But, their existence gives you the confidence to drive faster- how comfortable would you be to drive at 70mph on the motorway with no brakes? Similarly, many see derivatives as simply a costly risk management tool. However, we see them as the basis for good investment decisions that can contribute to higher returns.
So having the ability to drive faster with more confidence is one thing, but brakes also have the ability to stop you from a devastating crash. What has this to do with pension schemes? Well they aren’t hugely different. Their deficits require them to achieve a certain level of performance – a minimum investment return – so going too slowly (perhaps by disinvesting from equities through fear of a market fall) will result in a failure to meet their objective of eliminating their deficit. Yet market crashes can be extremely painful. Basic brakes are a simple mechanical tool. They are fundamentally as simple as pads against a wheel, as easy to apply as stepping on a pedal. Basic derivatives are also simple mechanical tools, but like brakes give you confidence. Deciding when to use derivatives is a rudimentary skill –using derivatives, as a way to reduce the pain of market crash, is far safer than trying to shift out of equities just in time.
Derivatives provide pension schemes with protection against volatile markets allowing freedom for greater allocation to equities, which should help it meet its investment objectives through anticipated higher performance. In addition, a larger asset base, achieved by avoiding market falls, will put a scheme in a stronger position to benefit from a market rally, adding to the overall performance a scheme achieves.
More advanced and effective braking systems coupled with skilful implementation will help a driver reach his or her destination safely in a significantly reduced time- if a Formula 1 car can slow down 1 second quicker then it will lap the circuit 1 second faster, thereby adding to performance. Skilled usage of derivatives can also add further value still. The combined use of derivatives to avoid losses at the right time and capture rising markets makes it possible to outperform a conventional equity investment. This comes from the underlying security arising from the mechanical properties of derivatives being enhanced further by skilful application (i.e. what derivatives to use and when).
Derivatives are often associated with risk management, which in turn is associated with sacrificing return. However, like brakes, the use of derivatives can enable pension schemes not only to manage the risk effectively but support their performance objectives.
Too good to be true?
Benchmarks for what is possible change as new tools are developed. The Formula 1 cars of today can do things that couldn’t be imagined 50 years ago but designers are still not complacent. Similarly, pension schemes today have more tools at their disposal, and these should be factored into trustees’ visions of what is possible. Derivatives were once the exclusive preserve of large institutions that could afford the high costs involved, but this is no longer the case. Derivatives are now being used cost effectively by schemes of almost all sizes. And in today’s choppy markets, they are more useful than ever.
Mark Davies and Masroor Ahmad are managing directors, asset solutions with River and Mercantile Group
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