Use of derivatives in pension-fund investing strategies today

We will borrow from Jean-Michel's work at CDPQ and previously, Air-Canada-Pension, to show the main goals of a progressive pension fund, the business drivers of change and explain the mechanics of liability-driven-investing

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Business drivers

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The main drivers of change at pension fund investing:

• Bringing investment management in-house
  • To prevent fraud risk.
  • To have more control on the portfolio day to day.
  • To reduce inefficiencies in monitoring and reporting.
• Liability-driven investing
  • A proper definition of risk with respect to the promises made to pensioners and accounting for the shortfall with respect to them.
  • Looking at all investment options at the same risk level and using credit availability to leverage low-risk positions
• Artificial Intelligence and FinTech
  • For higher quality, better focus on things that need human ingenuity
  • Costs have to be low. A.I. and FinTech help to lower costs.
  • Client-focus and transparency are key to next gen financial services

- Luc Fortin, CEO at M-X

The Investment approach of CDPQ

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The core tenets of one of the world's largest pension funds:

• Real economy

• Long-term

• Quality assets

• Efficiency of operations

- Jean Michel, total portfolio management at CDPQ

Liability-Driven-Investing

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• A "defined benefit plan" pension fund would start with formulating a duration of its liabilities.
• Jean recommends buying similar duration bonds to fully cover the liabilities. 
• However, Jean and team have put in a lot of work to leverage their AAA credit and cover their liabilities while still retaining 60% of the portfolio available to invest in growth instruments and projects.
• Hence they are covered in terms of their liabilities and they can focus on the long-term in their investments with virtually no real risk of failing their pensioners.

Liability-Driven-Investing vs Risk-Parity

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However, fixed-income and credit tend to be low risk and low-return.

With very low rates on both asset classes, pension funds serving defined benefit plans with much higher growth rate assumptions find themselves unable to invest in these asset classes.

Jean recommends the creative use of financial instruments to look at all three asset classes, Infrastructure-Investing, Equities and Credit at the same risk level.

Doing so should illustrate much higher expected returns in infrastructure and credit than equities.

Practitioners of Risk-Parity will see that this is exactly what Risk-Parity strategy would indicate as well. If you look into the origins of risk-parity, it's clear how risk-parity was invented to satisfy the requirements of liability-driven-investing

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