Pension Fund Use of Alternative Investments and Derivatives: Regulation, Industry Practice and Implementation Issues

Abstract

The financial and economic crisis had a profound impact on the financial position of pension funds in most countries. Whilst the magnitude of these losses is primarily related to the severity of the crisis, it appears that shortcomings in the implementation of investment strategies significantly amplified the deterioration of the financial position of some pension funds. In particular, many pension funds have increasingly invested in alternative investment categories and complex products in recent years. Subsequently, the financial and economic crisis heightened the concern of pension regulatory and supervisory authorities regarding pension funds’ use of alternative investments and derivatives. The Organisation for Economic Co-operation and Development (OECD) and International Organisation of Pension Supervisors (IOPS) conducted a survey across the IOPS and OECD member base to evaluate pension funds’ exposure to alternative investments and derivatives. The information garnered from the survey and discussed in this paper, provides a valuable indication of pension fund practices with respect to these investments and establishes whether the IOPS ‘Good Practices in the Risk Management of Alternative Investments by Pension Funds’ are being implemented. This paper is divided into five main sections. The first section reviews the regulation in place which aims to manage the potential risk exposures that alternative investments and derivatives present. This provides a useful backdrop for then evaluating the current market practices of pension funds’ investment in such instruments. The second section canvasses the implementation issues that a number of pension funds have faced in attempting to implement their investment strategies with the inclusion of alternative and derivative instruments. The third section highlights the potential risks that pension funds face when investing in alternative investments and derivatives, followed by the fourth section reviewing current risk management practices observed by pension funds in managing these risk exposures. The paper finally concludes with observations which can be translated into lessons for consideration by supervisory authorities when developing future pension fund regulation and supervision practices of alternative investments and the use of derivatives, whilst also taking into account the IOPS Good Practices.