Pensions have their reasons for abstaining from options — but are the reasons valid?

Pensions typically break down their assets across three asset classes: stocks, bonds, and alternatives, which may include real estate, hedge funds, and private equity. Options and other derivatives may fall under the alternatives category, which is often kept at less than 20% of total assets, noted Phil Gocke, managing director at Options Industry Council.

Aside from the perceived riskiness of options, another reason cited by pension plans for steering clear is that options and their related overlay strategies don’t fit neatly into a standard style-box configuration and would thus have to be labeled miscellaneous.

For pensions that are adopting or expanding options strategies, a prime motivation is to manage tail risk, which arises when an investment moves more than three standard deviations. In other words, if Google stock falls from $650 to $100, are there put options in place that will pay off and offset most or all of the losses from the stock?

Options can manage and reshape risk within a portfolio, according to Jay Strohmaier, senior portfolio manager at The Clifton Group, a derivatives specialist that manages $30 billion on behalf of about 170 institutions including pension plans, health-care plans, foundations, endowments, and Taft-Hartley plans.

“They can be used as a means to add risk, reduce risk and create very customized and asymmetric risk/return profiles that can sometimes better align with the specific risk management needs of clients,” Strohmaier said.

Still, options require understanding. “The successful integration of an options-based strategy often requires that investors take the time necessary to become better educated on the fundamentals and nuances of options trading,” Strohmaier said. “They have an additional layer of complexity that can be fairly confusing for those who don’t have experience with them, as opposed to stocks and bonds.”

Institutions can manage tail risk via multiple investment vehicles, including market-neutral or short-biased hedge funds, high-quality, conservative stocks, and gold. “These all provide some reduction of the exposure to equity risk premium,” said Terry Dennison, senior partner and U.S. director of consulting at consultancy Mercer.

Yet, options are the purest tail-risk hedge, according to Dennison. “Buying at-the-money put options is a pure tail-risk hedge, as it provides ‘first-dollar loss’ coverage,” he said, adding that investors can also hedge via more advanced strategies such as buy-put collars, put spreads and put-spread collars.

Aside from protecting against investment losses, options can also be used to ameliorate other risks such as upside risk, and the risk of being underexposed to risky assets vis-a-vis investment mandates.

While put options can directly offset tail risk, they are not without cost – another factor behind institutional reticence to deploy the securities.

“If many market participants believe that the market will decline significantly, the cost of insurance — the option’s premium — can become astronomical,” Dennison said. “Any tail-risk strategy is expensive to maintain continuously, as the options generally expire worthless.”