An asset-management firm focused on defined-benefit (DB) pension plans is making, to say the least, an unusual recommendation: that plan sponsors replace equities with call options in their portfolios.
The strategy will help lock in recent market gains, according to Donald Andrews, head of liability-driven investment strategy at Legal & General Investment Management America. Most plans are now are funded with more than 90 percent of their future liabilities, and some are over 100 percent. That’s thanks to the strong stock market and a modest recovery of long-term bond interest rates, which hit a historic low in late 2012.
The financial crisis and its aftermath had pushed the average plan’s funded status down to the 70-75 percent level. But now, with the higher funded status, it’s appropriate for plans to sell equities and buy calls, according to Andrews. That way they retain some upside exposure to possible future market gains, while plowing the rest of the cash from the equity sales into safe, fixed-income investments as a direct hedge against plan liabilities.
Legal & General Investment Management America isn’t a fly-by-night organization. It manages $42 billion of assets, approximately half of it in pensions. Its U.K.-based parent, Legal & General Holdings, manages $750 billion of assets globally, says Andrews.
Recommending call options, what the firm calls “stock replacement,” is “a new strategy we’re employing,” he says. “I’m not aware of other pension-asset managers currently doing it.”
That’s for sure. Other pension advisers reacted to news of the strategy with incredulity.
“I have 150 clients, including some of the largest pension plans in the nation, and there is not one that has done this or would even consider doing it,” says Rory Judd Albert, senior partner in the labor and employment department at law firm Proskauer.
A call option is a right, but not an obligation, to buy an agreed quantity of a particular financial instrument, often a stock or an index-based instrument, by a certain time (the expiration date) for a certain price (the strike price). Calls are typically purchased from stock and commodities exchanges.
Buyers pay a premium for the option. If the stock price rises above the strike price before the expiration date, the option holder can exercise the option and turn a profit. If the stock falls, the buyer’s downside is limited to the premium it paid.
Call options are considered expensive and risky in three ways, says Albert.
First is the premium. Second, option pricing tends to be volatile, though recently it’s been relatively steady.
Mark Ruloff, director of asset allocation for Towers Watson, says a call-option strategy by pension plans would not likely pay off over time because of the typical volatility in option pricing. “It might seem worth it right now, this year, but next year when you go to do it again, the cost of the option may be higher,” he says. “And it’s right when the market thinks things are going to take off that the price of an option will be most expensive.”
But the third reason options are considered expensive may be the most important. The potential for outperforming the market with an option is limited by time, usually three, six or nine months, or one or two years. Even if the underlying stock price or index level rises after you bought it, if it’s not in the money by its expiry, you’ve lost the premium with nothing to show for it.
That’s what makes options “anathema” to institutional investors, says Albert. “They’re long-term investors. They don’t care what’s going to happen in six months or a year. They want to know where the company and its stock are going to be a decade or three from now. Options by nature are risky and expensive, and institutional investors try to keep risk and expense down.”
In fact, he says, it would make more sense for plan sponsors to write call options and sell them in the market, rather than buy them. “The writer usually has the upper hand,” because it can set the strike price and expiry date wherever it wants. But his clients don’t want to dabble in options at all, he notes.
To Albert, the notion that plan sponsors should get out of equities in order to lock in market gains makes no sense. “Options are all about timing the market,” he says. “[Legal & General] is saying ‘look, the market indices are at all-time highs, they’ve got to go down and it’s going to happen soon.’ But no one knows what the future will bring in the market. What if someone told you a year ago that the Dow would be above 16,700 now?”
The Case for Call Options
Legal & General doesn’t seem bothered by the criticism. The strategy makes sense, at least right now, Andrews insists. In fact, he adds, it’s really nothing other than a next-generation relative of strategies plan sponsors have executed in the past to synthetically replicate equity exposures, like equity futures and equity total return swaps.
To Ruloff’s point, it is precisely because option pricing is low, right now, that plan sponsors should consider buying calls now, though not necessarily in the future, says Andrews, who notes that Legal & General has implemented the strategy for several U.S. pension plans this year. “We are very cognizant of pensions having a long-term outlook,” he says. “We know calls could be more expensive in six months.”
The upside or downside exposure of a stock-replacement strategy versus owning stock outright equates to purchasing a straddle, or an at-the-money call option together with an at-the-money put option, he notes. For May 2014, the average cost of such a straddle on the S&P 500 index, with a one-year expiry, was 11.89 percent of the index price, according to Macro Risk Advisors. That was the lowest level in seven years, during which the cost rose as high as 37 percent.
To illustrate how good 11.89 percent is, Legal & General calculated that if you could have replaced stock with S&P 500 index options for that price going back to 2004, you’d have outperformed long equities by an average of 4.97 percent on an annualized basis.
Outperformance happens, in this example, when the market moves more than 11.89 percent in either direction. If the market goes up by more than that, you exercise options for a profit. If it goes down by more than that, your loss is capped at 11.89 percent.
In most years, markets move by more than 12 percent, Andrews notes. “Buying calls at that price can replicate the upside exposure you would have had to equities, without the downside exposure,” he says.
Why is call-option pricing so low now? “Option prices fluctuate based on the relative fear in the market over time, and there’s generally a high level of complacency right now,” Andrews says. “Also, a lot of hedge funds and option players are selling down options because they’re searching for yield.”
Stock replacement doesn’t necessarily imply replacing all the stock in a portfolio with options. The range among the plans that implemented Legal & General’s call-option strategy this year was from 15 to 100 percent, according to Andrews.
Legal & General didn’t concoct the strategy out of the blue. “It’s widely used in the hedge fund and derivatives spaces,” says Andrews, who worked in those areas himself before joining Legal & General in 2013. “But it’s not that we’re trying to put pensions into hedge fund-type exposures or trying to make bets like a hedge fund. We’re trying to implement exposures in the most efficient way possible. Option strategies are just another arrow in our quiver to help pension plans ultimately de-risk their liability exposures.”
Photo credit: Wikimedia Commons, White House photo by Kimberlee Hewitt