The use of derivatives by U.S. pension funds to hedge risk will likely slow down because of the ongoing credit crisis, according to Watson Wyatt. The U.S. had begun to see an increase in the use of derivatives by pension funds over the last few years.

"At a time when pension funds would have benefited most from having well-considered hedges in place, market conditions have been against them," said Chris DeMeo, senior investment consultant at Watson Wyatt. "Since the start of the credit crisis last year, there have been significant delays in the execution of derivatives-based liability hedging strategies for pension funds. This has been due to documentation taking substantially longer to process because of more onerous legal conditions, as well as there being a general mood of risk aversion among banks.

At points during the year, the yields available were also not considered attractive, DeMeo said. "We have also noted very large increases in transaction costs for shorter-dated contracts. In light of more recent market events, it is unsurprising that some banks are now either less willing or less able to retain unhedged risks on their balance sheets, but the net result is that pension funds now have to delay the execution of these risk-reducing strategies, which we expect will also hinder their wider adoption."

For those funds that have these strategies in place, Watson Wyatt advises that they should ensure that both their documentation and collateral are robust, as primary security comes from these. In addition, funds should have diverse counterparties in place in order to manage the default-to-replacement risk. The firm also advises that, in the event of default, it is important for funds to replace positions quickly to minimize possible market loss.

"While Lehman Brothers' bankruptcy and ongoing volatile markets have perpetuated the very challenging investment environment, those high governance funds that use interest rate swaps will have found that they have proved their worth in managing deficit risk," said DeMeo. "As such, we expect pension funds and their sponsors to continue to use various derivative instruments, albeit at a slower rate, because of a broad realization that they can provide protection, enhanced performance and a better match for liabilities."