Pension funds across the world are meant to be low-risk financial instruments. They are allowed to take slightly more risks in some parts of the world as compared to others. However, for the most part, pension fund across the world is advised to stay away from risky instruments such as derivatives.

Derivatives have been known for playing a pivotal role in many market crashes. Hence, pension funds have been traditionally asked to stay away from derivatives. However, that has changed in the recent past. Pension funds are now allowed to have limited exposure to derivatives in most parts of the world.

In this article, we will have a closer look at how pension funds use derivatives to manage their portfolios in a better manner.

How Pension Funds Use Derivatives?

In most parts of the world, pension funds use derivatives in a restricted manner. The common restrictions which are levied on the use of derivatives have been explained below.

1. Pension funds must only take exposure to derivatives as a tool for risk management. They are not allowed to use derivatives for speculative purposes. This means that pension funds are allowed to take a derivatives position in an asset only if they hold the underlying asset.

   For example, if the pension funds have some investments in foreign currency, they would end up being exposed to foreign exchange fluctuations. In such cases, they can use derivatives to hedge their foreign exchange risk.

2. Pension funds follow a concept called liability-driven investing. As a part of this strategy, pension funds are required to ensure that they have an asset in place against every liability that the fund. Since the value of the liabilities can be volatile, derivatives can be used to ensure that the assets in question do not fall short of the required date.

3. Pension funds generally face risks from three or four variables. These variables are interest rate, inflation rate, forex values, and longevity. As a result, pension funds in most parts of the world are allowed to use derivatives to control these risks.

4. However, even despite all the above reasons, pension funds generally have a cap on the total value of derivatives that they hold. Regulators place this limit to ensure that the amount of assets held by pension funds is much greater than their liabilities. In most parts of the world, pension funds are not allowed to have more than 25% of their assets tied to derivative instruments.

5. Pension funds are required to obtain expert help for the valuation of derivatives. In most parts of the world, these funds are required to report the day-to-day values of the derivative instruments in their reports. However, if a pension fund has exposure to over-the-counter derivatives, it may not have such details. In such cases, regulatory authorities across the world have created detailed procedures which can be used to value the derivatives while creating periodic reports.

Why do Pension Funds Use Derivatives?

Pension funds have adopted the use of derivatives on a large scale. This is because the use of derivatives provides a lot of advantages. Some of these advantages have been listed below:

1. To Lock in Higher Returns: The main purpose of derivatives is to allow pension funds to lock in higher investment returns without the risk of a downside.

   For example, sometimes pension funds are able to find investments denominated in foreign currency which provide higher returns. In such cases, they get exposed to forex risks. Hence, they are unable to buy these assets.

   However, the pension funds can purchase the investment and nullify the forex risk with the help of a derivative. This will help them to lock in a better return. This is the case with many other investment opportunities. For instance, sometimes the fund may hold floating-rate bonds. In such cases, they can use derivatives to swap their cash flow for a fixed rate of interest.

2. Increase Investible Surplus: Derivatives also help pension funds to increase the number of investible funds. This is because derivatives help the fund to manage risks better. As a result, funds do not have to keep large amounts of money in the reserve to account for unforeseen risks. This additional money can immediately be channeled to the market to start earning extra returns for the fund. The end result is that the prudent use of derivatives can add to the bottom line of the pension fund.

3. Reduce Risks: The main purpose of derivatives is to help pension funds manage their risks better. Derivatives help remove the effect of many variables such as inflation and interest rates. As a result, investors are able to better predict their returns which in turn helps them to plan their life better. Derivatives help ensure that pensioners do not have to cut their standard of living in case unforeseen economic events take place.

4. Flexibility in Investments: Derivatives help in reducing the risk level of many asset classes. Hence, the asset classes which were not palatable for pension funds end up becoming acceptable. Derivatives help increase the range of financial instruments which can be used by the pension funds.

The bottom line is that derivatives have some utility for pension funds. Even though pension funds cannot use them in an uninhibited manner like hedge funds, they can and must find a way to include derivatives as a risk management tool in their overall strategy.