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Defined Contribution

European plans warming up to derivatives strategies

Karin Franceries said investors are moving to protect their increased equity allocation.

Hedging strategies are making their way into European defined contribution portfolios as plan executives look to protect returns in an increasingly volatile market environment.

Sources said the need to protect equity investments is all the more acute as expected interest rate increases in Europe are set to take a toll on portfolios.

Retirement plan executives started preparations due to concerns that aggregate eurozone equity and fixed-income returns are projected to drop to near zero over the next five years from around 5% now, according to Amundi.

Yet asset owners are continuing to allocate to equities as a better option than bonds.

In recognition of the potential for increasing volatility, asset owners are choosing multiasset strategies that use derivatives such as put and call options to protect their positions if markets fall, sources said. Asset owners in Germany, Italy, France and Belgium are all looking to deploy such risk-limiting strategies that can help to sell equity positions when markets go down.

Karin Franceries, head of institutional advisory at Amundi in Paris, said asset owners in Europe are reducing fixed-income allocations to an average of 60% from 75%, and moving the assets to equities. "But that's a huge jump," she said, "so they are looking to buy the protection on the downside for that 10% to 15% of equities."

While defined benefit plans and hybrid plans have used derivatives for portfolio protection for years, it is only recently that such strategies have begun showing up in defined contribution plan default portfolios.

In some countries, including Belgium and France, defined contribution plans are turning to derivatives-based strategies known as dynamic hedging programs. These strategies insulate portfolios against a loss by short-selling stock index futures, since derivatives such as put or call options can mean sacrificing some of the upside.

The €500 million ($582 million) KBC Pensioenfonds, Brussels, recently introduced a dynamic hedging program into the default fund of its defined contribution plan. The program is applied to the 80% of default fund assets in bonds and equities. It increases or decreases equity vs. fixed-income exposure over the course of each quarter depending on the markets.

"The program could move from 60% investment in equity, if the equity market increases, to as low as 20% if the market goes down, by trading index futures," said Luc Vanbriel, chief investment officer of the plan.

"We think of it as a multiasset portfolio, as we no longer consider individual asset classes. It allows us to decrease the total volatility of the (default option's) portfolio. And it is a better way than to look at the volatility of individual asset classes because of correlations."

Multiple goals

Sources said a dynamic hedging strategy can help a DC plan to achieve multiple goals at the same time. With many plans battling to meet the retirement objectives of a diverse workforce, a dynamic hedging program can capture value for younger groups of participants, whose investment needs are more suited to growth assets, while at the same time providing the security of bonds.

"On one hand typical participants that are about to retire can benefit from not having to take the risk, but on the other hand the participants with longer retirement horizons can take advantage of the more aggressive equity exposure," Mr. Vanbriel said.

The mechanism starts at a 60% allocation to equity, and using futures swiftly adjusts the exposure based on market conditions. However, in Belgium plan sponsors must guarantee at least a 1.75% return to DC plan participants on an annual basis, so if an aggressive exposure to equity produces losses, participants nearing retirement still receive a positive return.

In its dynamic hedging program, KBC trades futures. There is a set threshold, or floor, that is the lowest return the plan would be willing to accept. As the market changes, the floor moves with it. "We increase the floor on a quarterly basis if the fund's (net asset value) has increased, in order to protect the gains. We decrease the floor on a yearly basis if the fund's NAV has decreased in order to reset the allocation back to target," Mr. Vanbriel said.

"The program could go as far as selling all of the equities and ending up completely in cash. The flexibility allows for the program to be used temporarily on all or part of the portfolio. And it doesn't require actively changing the allocation," Mr. Vanbriel said.

KBC Asset Management provides the dynamic hedging program to the retirement fund.

But despite the excitement, others said the strategy has drawbacks.

"We haven't seen many European defined contribution plans introducing dynamic hedging programs yet" because they carry certain risks, said Ralph Frank, head of defined contribution at consultancy firm Cardano in London.

Sources said the risk of adjusting the floor is too high and there is no real guarantee the floor won't be breached.

In France, Amundi offers a liquid investment product similar to KBC's in-house hedging program in which the fund's net asset value is protected regardless of the market conditions, providing asset owners with protection. Amundi itself guarantees to clients that the return won't fall by more than 10% under any market conditions.

In addition, because of the floor adjusting, getting out of risky assets during a downturn in the market might mean plans won't make additional money on the rebound because an investor might have derisked before equities return to gains following a market shock.

Added Amundi's Ms. Franceries: "A big risk for these strategies is the opportunity cost. We've seen this in late 2008 when, following huge losses, investors went out of the market and then were not invested in risky assets during a rebound in April of 2009. "A plan may not be quick enough to change to get back into the market to have that performance trade-off," she said.

While using typical derivatives tends to be costly for DC plans due to their scale, money managers could come to the rescue by making use of them in their multiasset offerings.

Growing demand

Isabelle de Malherbe, head of product specialists-structured solutions at Amundi, said the firm's offering, called Protect 90, saw greater demand in 2017. "We have grown assets under management to €7 billion from less than €3 billion in 2016. This year we are also seeing demand from Japanese investors."

Brian Henderson, partner and director of DC consulting at Mercer LLC in Edinburgh, said multiasset money managers in the U.K. that hold defined contribution assets in their portfolios increasingly are putting emphasis on exposure to derivatives to offer either return generation or to protect against a drop in the markets.

"Multiasset portfolios might hold a number of such contracts across a range of different market trades or bets. This is a relative value play so an investor is not relying solely on market beta," Mr. Henderson said.

But Julien Halfon, head of pension solutions at BNP Paribas Asset Management in London, thinks there is an issue with relying on the multiasset strategies: "You don't get the best-in-class manager for each asset class."