Many public pension plans resist options, largely due to perceptions that the securities add risk to a portfolio. But for some plans, adopting an options strategy has worked out well.

“It’s not free money, but it is income and hedging,” said John Colville, chief investment officer of the City of Sacramento pension plan, which manages about $300 million.

Speaking Sept. 27 at an industry event at the New York Stock Exchange, Colville said options have generated income while reducing volatility and boosting the Sharpe ratio of the portfolio, which measures excess return. Options allowed the Sacramento plan to match the return of the benchmark S&P 500 over one recent period, whereas otherwise the return would have fallen short, Colville said.

Colville is permitted to sell covered calls, which generate income, and buy protective puts, which hedges against downside, on up to 30% of the Sacramento portfolio. The plan has moved in “baby steps” to reach that level due to wariness on the part of some in the pension brass.

Sacramento’s challenges are similar to those faced by many other public pensions: the plan is 78% funded and there are more beneficiaries than active members. “We are paying out more than we are taking in,” Colville said.

With interest rates stuck near historically low levels, the task of meeting liabilities is much more difficult, hence the need to explore alternatives such as options.

“People are looking for yield and looking to protect principle,” said Kevin Duggan, vice president of equity products at Ontario Teachers Pension Plan, which manages about $125 billion.

Duggan noted that Canadian pension plans are comparatively “derivative-literate” largely due to government guidelines that have encouraged their use. “We are able to manage money in a progressive way,” Duggan said.

Options are more on pensions’ radar since the financial crisis of 2008-2009 disproved the notion that diversification assures adequate returns. “There is no asset mix that will get you fully funded – it doesn’t exist,” Duggan said. “Alpha is what’s needed to make sure that pension promises are kept.”