JOHANNESBURG -- The use of financial derivatives by South African pension plans has increased dramatically in the past three years and coincides with a country-wide shift to defined contribution plans.
The latest annual report of the Registrar of Pensions at the Financial Services Board, South Africa's financial services watchdog, showed a 140% jump between 1997 and 1998 in the use of derivative market instruments by South African pension plans.
The FSB put the fair value of these derivatives instruments at 220 million rand ($33.8 million) at the end of 1998.
But market sources said the FSB report sharply underestimates the use of derivatives by South African pension plans. They said the use of derivatives by pension plans had grown rapidly in the past few years and that figures provided by the FSB were just the tip of the iceberg.
The FSB's miscalculation is partly because a number of local pension plans submitted their 1998 financial statements late, but more importantly because most plans prefer to use equity derivatives sold through the over-the-counter market rather than on the local futures exchange.
FSB pensions specialist Renier Botha admitted the numbers may have been understated. He said the regulator was trying to make more precise the way pension funds report derivative positions and would consider getting plans to distinguish between exchange-traded and OTC instruments.
OTC derivatives are not subject to the same reporting rules as exchange-traded instruments, and most pension plans preferred the flexibility of buying OTC equity derivatives, as they could be designed to suit the plan's specific needs, said Ram Barkai, head of structured solutions at Cadiz Investment Bank, Cape Town.
According to Lance Vogel, director of Peregrine Structuring Ltd., a boutique financial services company in Johannesburg, 95% of derivatives activity by pension plans took place in the OTC market. He estimated activity in the past two years was in excess of 20 billion rand.
Mr. Barkai estimated Cadiz had sold derivative structures -- guaranteed funds or zero-cost collars that put derivatives instruments together to get a certain type of return or hedge -- worth close to 10 billion rand during 1999.
The lion's share of this business is the result of pension schemes, particularly those of government-owned companies, converting to defined contribution plans.
So far, significantly less than half of South Africa's 600 billion rand in pension plans has been converted to defined contribution schemes, said Mr. Vogel.
Iscor Ltd., Pretoria, was one of the first state-owned companies to convert its pension assets to a defined contribution scheme, in mid-1998.
The 12 billion rand Iscor fund decided to hedge 3.5 billion rand -- 60% of its domestic equity portfolio -- against falls in the underlying market during the switch to defined contribution, said Johan Potgieter, deputy general manager-services at the plan for employees in the country's iron and steel industry. When converting from a defined benefit system, pension plans have to guarantee to maintain the market value of the underlying assets.
In April 1998, the plan bought a series of zero-cost collars -- by selling put options and buying call options -- on its equity investments to retain the value of the underlying assets. The plan's timing could not have been better, as the strategy was in place during the middle of 1998, when emerging stock markets experienced terrific volatility and losses following Russia's default on its sovereign bonds. The return on the Iscor plan's domestic equity portfolio that year was 20%, compared with -10% for the JSE All Share Index, said Gerhard Engelbrecht, the plan's deputy general manager for investments.
The Iscor plan continues to use derivatives to give it exposure to illiquid underlying equities, but stays within the 5% ceiling imposed by the trustees on the use of derivatives.
The 35 billion rand Transnet Pension Fund, for employees of the state railway system, is in the process of restructuring its defined benefit plan and launching a defined contribution scheme. The process is due to be completed by July, and sources close to the plan said it was using a strategy similar to that of Iscor in order to hedge its underlying assets.
Plan officials could not be reached for comment.
Once pension plans have converted to a defined contribution system, they also are likely to make use of guaranteed funds in the range of investment options they offer their members. Guaranteed funds commonly use a combination of equity options to give investors protection against falls in market values. These option strategies also put a cap on total returns.
Cadiz' Mr. Barkai said these strategies are in demand among older members of South African pension schemes who want to maintain the value of their assets in the face of market volatility.
But demand tends to be cyclical for guaranteed funds, as they could be expensive during periods of high volatility, said Mr. Vogel. And Ralph Frank, senior director in investment consulting at Alexander Forbes Financial Services, Johannesburg, said his firm tried to discourage the use of guaranteed funds due to the costs involved.
A number of pension plans also are making increased use of equity derivatives as they change their asset managers more frequently than in the past, said Mr. Vogel. An increasing number of plan sponsors are dropping balanced managers and awarding specialist mandates or adopting a multimanager approach. Equity derivatives are important to neutralize risk during portfolio transitions, particularly in a market like South Africa's, which is characterized by volatility and some illiquidity.
While the use of derivatives has increased sharply in the past few years, their application in South Africa is still limited by plan trustees' concerns about gearing leverage and the risks involved.
"Its not just as simple as selling a zero-cost collar; you have to look after these guys. Another Orange County would kill this market," added Mr. Barkai, referring to the 1994 scandal in the U.S. when highly leveraged bets with derivative instruments pitched Orange County, Calif., and its investment pool into bankruptcy.