Pension Funds and Financial Innovation

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Pension funds have played a critical role in the evolution of the markets for debt and equity securities and their derivatives in the U.S. over the last 15 years. The new securities and markets can largely be explained as responses to the investment demands of pension funds in an environment of increased interest rate volatility and tighter regulation. Defined benefit pension plans offer annuities that have a guaranteed floor specified by the benefit formula. In order to minimize the cost to the sponsor of providing this guarantee, there is a strong incentive to invest an amount equal to the present value of the accumulated benefit obligation in fixed- income securities with a matching duration. The pursuit of duration matching and related immunization strategies by pension funds has contributed to the emergence and rapid growth of markets for zero coupon bonds, GIC's, CMO's, options, and financial futures contracts. Recent changes in accounting rules (FAS 87) and tax law (OBRA) are likely to reinforce the use of immunization strategies.

Published: Financial Management, Vol. 19, No. 3, pp. 11-22, (Autumn 1990).

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