Can Derivatives Solve the Pension Crisis?

New research shows they can indeed improve returns.

February 12, 2014

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187265_life_preserverPension funds around the world are struggling to deliver on the pension promise. Market volatility doesn’t help, of course. And historically low interest rates haven’t helped either, even though rates appear to be on the rise. So what can pension funds do to solve their return problems? Some have turned to derivatives for help. Most notably, the Healthcare of Ontario Pension Plan (HOOPP) and the Danish ATP have both employed derivatives as a hedge for different parts of their portfolios. It’s working for those two large plans – but what about other funds?

A relatively new research paper that appeared in the International Journal of Pension Management explores how derivatives can help pension plans manage risk and boost return. In the paper, “When Do Derivatives Addd Value in Pension Fund Asset Allocation“, the authors explore whether or not using equity- and volatility-based derivative instruments can help the pension industry meet the pension promise in challenging times. To do this, the authors consider “the design problem for optimal derivative strategies in the context of strategic asset allocation.”

For any plan sponsors considering a more comprehensive derivatives strategy, this paper could offer some helpful tips.

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