The investment landscape facing pension fund trustees and corporate sponsors has changed significantly in recent years, with the range of investment strategies now available broader and more diverse than ever before.

This allows risk and reward to be controlled and managed to a greater extent, but also substantially increases the already heavy burden of education required for trustees to decide how to invest appropriately the assets they are responsible for. This burden is especially heavy in the case of complex strategies involving financial derivatives.

When might a pension fund want to invest in options?

The following are examples of common cases in which options (and not just equity options) could be considered along with other perhaps more traditional strategies.

• A tactical view – the trustees (and their advisers and perhaps the company sponsor) may have a view that certain markets or assets are mispriced. 
   
• Dynamic strategies – many pension schemes distinguish between a medium to longer-term aim of substantial reductions in investment risk and a shorter-term preference to retain higher levels of risk in the hope of benefiting from strong returns through an improved funding position. There is thus an objective to change strategy over time in response to developments in the pension fund's financial position.
   
• Loss limitation – risk and potential return go hand-in-hand and a concern of many trustees and sponsors is the risk of a worsening of the funding position which comes with strategies that have the potential to generate strong returns. Trustees and sponsors will seek to strike a balance between return potential and loss limitation.
   
• Profit limitation – trustees and members of defined benefit pension schemes will naturally tend to see a point beyond which a further improvement in the funding position is of no real value: the benefits are fully covered on even the most conservative valuation basis (such as the “buy-out” solvency basis), perhaps even with a margin above the level to allow for uncertainty attaching to future demographic experience, and there is no prospect of benefit improvements or employee contribution reductions.

Equity index options

Options on individual equity stocks are readily available, but decisions taken by pension fund trustees are typically taken at the asset class level and so options on equity market indices will be of greatest interest to pension fund trustees. Exchange traded options are necessarily standardised and based on specified indices but it is in principle possible to obtain an option on any market index through a direct transaction with an investment bank, that is, on an over-the counter- or “OTC” basis. The following are the principal equity market indices used for the OTC options on the world’s major markets:

Equity option strategies

There are a very large number of different option strategies that could be followed. We concentrate on five equity option strategies more frequently encountered by pension funds at present:

• Buying a put option in combination with an existing equity portfolio. 
   
• Buying a call option in combination with a cash portfolio.

These two are essentially very similar, ignoring the basis risk, and the same for European options of a given term and strike. The choice between them is a function of second order factors, such as transaction costs, the existing and intended future equity exposure, the investment management structure and the significance of basis risk.

• The “collar” – buying a put and selling a call (which a higher strike than the put) on an equity portfolio. 
   
• The “put spread” – buying a put and selling a second put with a lower strike than the first on an equity portfolio. 
   
• The “put spread collar” – a put spread together with selling a call at a higher strike than the put strikes.  

Liability relative risk

The pay-outs on standard equity index options are defined in absolute terms but pension fund trustees are concerned with risks relative to liabilities. There are two ways to make equity options effective in liability-relative risk terms:

• Remove the interest rate risk on liabilities through interest rate and inflation swaps.
   
• Transact options whose pay off is derived from the performance of equity relative to liabilities.

Under the former, the swap portfolio implicitly changes the benchmark for measuring equity risk from the interest rate sensitive liabilities to cash and, in these terms, an equity option which depends upon the absolute return on equity markets is more effective. This is potentially the more transparent way of addressing the issue. The second approach is less common, and would necessarily be a bespoke arrangement and so would present greater problems of pricing transparency, but could conceivably be lower cost overall. 

Deciding on the term of an option

This is potentially one of the more tricky decisions to make in designing an option structure. On the one hand, conventional thinking would suggest that pension funds should be thinking in terms of the long term (and therefore looking to long term options) whereas, on the other the hand for an option strategy may well be to limit downside associated with equity in the shorter term, and a long-dated option will provide an imperfect hedge for shorter term movements in the underlying. 

Other considerations in using options

It is worth mentioning a few further practical considerations:

• Funding and Accounting – most ongoing funding bases take some advance credit for outperformance of risky assets such as equities over liability-hedging gilts or swaps. Trustees would need to understand how the use of options could affect these assumptions. 
   
• Counterparty risk and collateralisation – when a pension scheme buys an OTC option it has exposure to a counterparty. If markets move to increase the value of the option, the counterparty exposure moves with it. To minimise the credit risk attaching to such exposure, options can be collateralised (as interest rate and inflation swaps used by pension schemes tend to be). 
   
• Segregated option portfolios, fund “wrappers” and structured notes – an option could be transacted directly with a counterparty or indirectly through another structure such as a pooled investment vehicle, life insurance policy or structured note. 

Conclusion

In examining the benefits of option strategies, trustees should identify the investment objective the options are designed to achieve, whether this be taking a tactical view on the direction of equity markets, or a longer-term strategic aim of controlling potential losses from equity market falls or benefiting through the sale of potential future profits of no benefit to the pension scheme or its sponsor.

In general, it is likely to be easier to make a case for the use of options and to decide precisely what form those options should take where the trustees and sponsor are able to articulate clear and quantitative objectives defined in terms of the pension scheme’s financial position (and therefore objectives which take due account of the risk factors inherent in the liabilities).

Whatever the objective, option-based strategies should justify themselves relative to other strategies the pension scheme could follow.