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Pensions to Tackle Counterparty Risk

Date: Wednesday, October 22, 2008
Author: Raji Menon, Thomson Reuters

The fallout from global market turmoil is forcing pension schemes to re-examine their investment risks and could result in new guidelines outlining how they can manage their exposure to counterparties.

The National Association of Pension Funds, whose members hold assets of around £800 billion ($1.35 trillion), said it is working on developing information—which could form the basis of new guidelines—to help its members better understand the risks they run through counterparties.

NAPF chairman Chris Hitchen told Reuters: "There's going to be much more focus going forward on counterparty risk; understanding exactly where money is being held and what collateral requirements are needed on stock lending—all those sort of 'hygiene' issues have really come to the fore in the last month or two."

The collapse of Lehman Brothers Holdings Inc. last month and the failure of Icelandic banks have underlined the need for pension schemes to establish good practice in this area, he said. Lehman acted as counterparty to several billions of dollars of interest-rate and inflation swaps that some pension funds used to hedge their risks.

"We all need to be much clearer than perhaps some of us were as to what risk we are running with what counterparties. There are banks that you couldn't have imagined coming under question that are now coming under question. So I think it's important we know where the risks are," Mr. Hitchen said.

Mr. Hitchen, who is also chief executive of Railpen Investments, which manages the British Railways Pension Scheme with assets of more than £20 billion, defended pension funds' investments in hedge funds.

"Hedge funds investments have had a tough time this year, but have provided us with quite a lot of protection compared to investing in equity markets," he said. "Hedge funds typically are showing returns that are negative single digit, whereas equity markets are down 30% so they are kind of doing the job that they were meant to do in protecting some of the downside."

Hedge funds are viewed as a diversifier, but with many posting negative returns, some pension funds have questioned whether they do provide returns uncorrelated to equities and bonds.

Railpen has around 8% of its assets invested in hedge funds.

Mr. Hitchen said the market turmoil could prompt a greater shift into bonds. "Governments are likely to issue a lot more debt in future purely to make good on all the guarantees they have been giving. So bonds may get cheaper in the future and if that happens then pension funds will buy more of them and could possibly move into liability matching strategies."

By Raji Menon