Impact & Use of Leverage

Leverage to Meet the Pension Promise

Author:

Dr. Serguei Zernov, PhD, Global Risk Institute Special Advisor

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Leverage to Meet Pension Promise


ABSTRACT

The article discusses use of leverage in the context of defined benefit pension plan investment. It defines the term leverage, discusses how leverage creates value using a simple one-period model and stylized market assumptions, examines risks associated with using leverage and reviews methods and best practices to mitigate and manage these risks. The article describes stylized cases of using leverage in practice of managing pension investments.

 

Introduction

The term leverage in the context of pension investments is a frequent subject of discussions in boardrooms of pension plans and at investment committees. The topic sometimes escapes offices of investment managers and regulators and fi nds itself in the press: for example, a title in Financial Post warns the public that Canada's public pension funds are piling on leverage - and risk, warns Moody's[Lev, 2017]. The Financial Post article refers to a short note on Bloomberg web site, and the latter refers to a research report published by Moody's, a rating agency [Mercer, 2018].

The original material in the Moody's publication indeed raises questions regarding the potential impact of the current economic environment and the use of leverage on the creditworthiness of Canadian public pension plans, but it is much less alarming than one could think reading the title in the Financial Post. The objective of this article is to define the term leverage as it applies in pension investments, describe uses of leverage, present an argument that for many pension plan managers leverage is essential in order to deliver the pension promise and that leverage, when used correctly, reduces investment risk at the same level of expected returns. We will describe risks associated with the use of leverage and how these risks can be mitigated.