The term "derivative" is used to describe any
of a number of financial instruments or contracts whose value
"derives" from the value of another asset or market index.
Pension funds, like other investors in global capital markets, have
benefited from the rapid evolution and innovation in financial
The Employee Retirement Income Security Act of 1974 (ERISA)
established current standards of conduct for private plans.
ERISA requires that plan fiduciaries make investment decisions that
provide the best possible assurance that the pension promise will
be honored; therefore, the overall return on the funds should be
maximized subject to a prudent level of risk. Fiduciaries
reduce the risk of the total portfolio by diversifying investments
among and within asset classes. Derivatives are an important
tool for efficient implementation of investment decisions.
The use of derivative instruments has grown rapidly over the
last 15-20 years and has moved into the mainstream of
finance. Pension funds and their investment managers use
derivatives to implement asset allocation decisions, manage
currency exposure, and manage the maturity of fixed income
portfolios. Through derivatives, the complex risks that are
bound together in traditional instruments can be separated and
managed independently. In short, derivatives are
cost-effective tools for implementing investment strategies and
controlling risk. Their prudent use enhances the benefit
security of our private pension system.
A formal survey of CIEBA's members regarding their use of
derivatives was last conducted in 1994, in the aftermath of a
number of companies having problems with derivatives. At that time,
the median private pension fund's commitment to derivatives was 7.9
percent of plan assets. The survey indicated that 85 percent
of the 118 respondents, (representing 95 percent of the $613
billion in assets under management at that time) used derivatives,
primarily exchange-traded futures, options and foreign currency
forward contracts. Although no survey update has been made,
anecdotal evidence suggests that derivative usage continues and has
likely increased due to the increasing sophistication and
understanding by senior financial management.
The use of derivatives to create highly leveraged positions
within portfolios has resulted in large and highly publicized
financial losses by a small number of investors. These
investors ranged from very speculative and sophisticated hedge
funds to banks, governments, corporations and mutual funds.
Notable examples are Gibson Greetings, Sumitomo, Procter &
Gamble (1993), Barings (1995), and Long Term Capital Management
(1998). However, CIEBA survey respondents as a group undertook
minimal leverage, both implicit and explicit, in their
application. Additionally, the majority of respondents and
their investment managers have policies, procedures, and controls
with respect to the use of derivatives.
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