Investment banks horning in

NEW YORK — Investment banks are pitching corporate chief financial officers, treasurers and chief investment officers on complex solutions to their pension plans' unfunded liabilities

Many of these solutions involve derivatives; all seek to deliver additional alpha and align pension assets and liabilities.

The brokerage units at investment banks stand to gain from providing these investment solutions, which include using interest rate swaps to synthetically increase the duration of a plan's bond portfolio in order to align assets to liabilities, using futures and total return swaps in portable alpha strategies to synthetically gain exposure to a certain index, and overlaying a plan's equity portfolio by writing call options to beef up returns.

Merrill Lynch & Co., New York; JPMorgan Chase & Co., New York; and Morgan Stanley, New York, are among the big investment banks placing greater emphasis on providing investment solutions to corporate pension plans and their consultants. One part of the approach of some of the firms is to create the position of pension strategist or new product development specialist to help educate corporate financial executives about these new strategies.

"Both myself and the treasurer are getting more pitches from investment banks as we have become more sensitive to liability risk," said one executive who helps oversee a $4.2 billion corporate pension fund. (He and other corporate executives contacted for this story would not allow their names to be used.) "They have mostly pitched derivatives strategies. We use some swaps to overlay a small portion of our bond portfolio. I don't really mind (getting pitches from investment bankers). Basically, as plan sponsors, we need to take the time to really understand these strategies and the fees from them."

The chief investment officer at a $7 billion corporate fund said the number of pitches from investment banks has increased since the tech bubble burst in 2000. "They are really pushing the use of derivatives," he said. "They are not bad strategies; we're currently talking to investment banks about using rate swaps to increase the duration of our bond portfolio.

"Both the chief financial officer and I understand these strategies and the costs associated with them, but I could see how some corporate plan sponsors might not."

Industry executives at money management firms say pension executives should be wary because these complex derivatives strategies are difficult to understand and could be expensive. In many cases, they say, there could be simpler ways to execute liability-driven investment strategies or change risk exposures than using derivatives.

"All of my clients are getting pitches from investment bankers about doing a big trade and running a substantial profit for the investment banks," said Barton Waring, managing director and chief strategist at Barclays Global Investors, San Francisco. "The kinds of things I'm hearing about are using swaps to extend duration, and the use of put options to protect against equity downturns. For investment banks, these strategies are huge — these are multibillion-dollar swap deals."

Mr. Waring said more simple strategies could often be used to decrease risk or align assets to liabilities. "For example, all put options do is reduce beta exposure in the equity markets. But if you want to decrease equity risk, why not just decrease your allocation to equity and move into bonds?"

He added: "It's important for the bankers who are pitching complex investment strategies to pension plans to have an investment background and be familiar with regulatory policy."

Mickey Strasser, co-head of the global alternatives strategies group at Merrill Lynch and head of its 2-year-old global pensions and endowments group, said executives on the trading and investment banking side of the firm work with CFOs, treasurers, CIOs and consultants to deliver solutions for their pension funds. "Many firms have been looking at asset-liability management in terms of quick opportunities. We want to be educators and thought leaders in this area," Mr. Strasser said.

"The key is to find the individual at a company who is responsible for caring about its pension plan and how it might affect the company's balance sheet and shareholders, whether it is the assistant treasurer, chief financial officer or chief investment officer. There is an intense focus on asset management. The asset-liability situation (at corporations) has now taken front stage … It's on the news nightly. In terms of pension topics, it's crucial we work with our own bankers and relationship managers to deliver a thoughtful solution to our clients."

Michael Peskin, managing director in the global capital markets group at Morgan Stanley, said the firm's investment banking side has always worked with corporations to deliver pension solutions. But now, with potential regulatory changes on the table and the equity markets delivering flat returns, the firm has placed a greater emphasis on discussing pension plan management with treasurers and chief financial officers at corporations. "Corporations have entered into a lot of swaps in their pension plans, and that's being fueled by the development of the derivatives market. They have also become sensitive to interest rate risks. Swaps have become a popular way of hedging that risk."

Mr. Peskin warned, however, that corporate executives must understand derivatives before they use them. "It is true that any swap is complex. For some plans, they are inappropriate if the chief investment officer is not comfortable with them. In that case, they shouldn't be doing it."

Morgan Stanley helped spark the renewed interest on the part of investment banks in unfunded liabilities, when it served as the lead underwriter for a bond issue from Detroit-based General Motors Corp., which issued $17.1 billion of multicurrency bonds and convertible securities in 2003 and pumped about $14 billion of the proceeds into its pension plan in order to help fund its liabilities.

That investment banks are pitching corporate executives about their pension plans is nothing new. In the late 1980s and early 1990s, investment banks encouraged corporations to implement liability-led investment strategies, including issuing debt to fund liabilities and implementing surplus optimization strategies. There was a strong focus on unfunded liabilities after the Financial Accounting Standards Board adopted Financial Accounting Standard 87, which required companies to report the liabilities and costs associated with their pension plans but allowed them to engage in actuarial smoothing.