Martin Johnson of P-Solve, looks at how investment strategies in pensions have changed with the demise of Lehman's. Company finance directors and treasurers have new operational issues to consider in pensions' investment. Lehman's default on counterparty risk in derivatives means trustees and companies face even more problems.

Those in corporate finance and pension fund trustees are under threat on all sides from a 'perfect storm' of adverse market conditions that are the worst in living memory and threaten the very sustainability of pension payouts for decades to come.

With an economic recession now in full swing and massive falls in the property market, pension fund equity and property assets face swinging mark-downs in valuations, while at the same time, rising inflation and falling interest rates are causing pension liabilities to shoot up, giving a double whammy to burgeoning pension fund deficits.

With company sponsors suffering from the economic downturn, the employer covenant to the trustees is weakening, and while the government remains preoccupied with trying to shore up the ailing financial sector, trustees must wonder whether they can continue to rely upon the safety net provided by the Pension Protection Fund.

Until last week, trustees who had attempted to mitigate their funds' exposure to interest rate, inflation and equity market volatility by using derivatives probably had taken for granted that these contracts would perform their required function. They may not have given enough thought to what might happen if their swap counterparty defaulted. After all, surely the big investment banks were too big to fail?

The recent bankruptcy of Lehman Brothers has highlighted the increased probability of counterparty defaults and the resulting operational issues for institutions with derivative contracts in place - old contracts must be terminated in an orderly fashion, new contracts put in place at competitive rates and collateral calls managed regularly to minimise the potential impact of future market events.

At the same time, company finance directors and treasurers are becoming all too aware that the knock-on effects of pension risk for funding higher contributions and volatile equity valuations require independent action on the corporate side. The use of an overall 'risk budget' would allow corporates to assess how much risk is being incurred across all aspects of the business - pensions, operations, financing, hedging, etc. - and what is the cost of hedging or eliminating these risks, thus allowing companies to determine how the budget should be spent across these areas and how risk mitigation should best be implemented. What the events of the last seven days have made clear is that professional market participants are best placed to react immediately and decisively to rapidly changing market events, and those end-users - corporates, pension funds and traditional investment advisers amongst them - that are not actively trading in the market on a day-to-day basis will find themselves at a pronounced disadvantage.

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In these uncertain times, trustees and corporate managers are seeking more than just the most appropriate advice. They are looking for an independent and objective market participant who understands their strategic goals, to whom they can delegate the implementation of that strategy and who has the experience and standing in the market to ensure best execution, even in the most challenging of conditions. After all, those funds that had Lehman Brothers as swap counterparty and have moved quickly to put on new trades in the market are still much better placed than those that have not hedged their interest rate and inflation exposure at all.

More and more trustee boards are seeking to move in this direction, and the division between delegated advice and liability-driven investing is becoming increasingly blurred. By overlaying derivatives onto existing portfolios, the asset allocation decision can be made more flexible, cost-effective and responsive to market movements compared to the wholesale buying and selling of large blocks of shares and bonds.

Trustees need to expect more from the investment advice they receive. Investment strategy must be reviewed more frequently, and long-term strategic decisions need to be supplemented with tactical adjustments to take advantage of changing market conditions. Rather than shying away from derivatives, as some commentators have suggested, trustees should seek a more comprehensive service provision, from derivatives training, hedge design and assistance with legal documentation, through to trade implementation, active collateral management, position monitoring and reporting.

The demands being placed on trustees and corporates in terms of financial knowledge and derivatives education have increased rapidly and substantially over the past few months. The danger is that some fiduciaries have regarded these issues as too difficult and/or too unlikely to make them worthy of detailed consideration. The events of the past week have shown yet again that the detail is where the devil lurks, and that seeking help for difficult issues is a better course of action than denial.

Martin Johnson is investment director in P-Solve's Risk Management Solutions team. P-Solve is the specialist investment consultancy and asset management business and a division of P-Sigma Investments Limited which is authorised and regulated by the FSA and part of the Punter Southall Group of Companies. This document contains expressions of opinion which cannot be taken as fact. The commentary provided is based on currently available information and on certain assumptions which may be subject to change without notice.