Crisis in the global economy may be knocking the value of most UK pension funds off course, but it is actually helping swell assets at the £12-billion ($19-billion) Pension Protection Fund (PPF). Established in 2005 along similar lines to America’s giant Pension Benefit Guaranty Corporation, the PPF absorbs the assets of defined-benefit private sector schemes when sponsoring companies go bust and honours their pension liabilities. As the recession continues to claim corporate scalps, PPF assets are steadily growing by around $3.2 billion a year, with some 120 schemes transferring assets to the lifeboat fund last year. To date, the fund manages assets and liabilities from over 500 schemes.
“The current rate of insolvencies and the number of schemes we are assuming responsibility for is linked to banks tidying up their balance sheets and bringing companies to the wall,” says Martin Clarke, executive director of financial risk at the fund. And even when the recession abates, PPF assets will still accrue from investment growth and new claims for years to come. “We estimate we’ll have $95 billion worth of assets under management by 2030,” says Clarke. “This will take us to end of our active period. There are only a finite number of defined-benefit pension schemes that can come onto our balance sheet. After this our liability profile will decline as our member population ages.”
The advantages of scale
For now, the fund’s growth is encouraging diversity and an ability to tap a wider range of assets for the first time. The conservative strategy hasn’t changed – it only targets returns of 1.8 per cent above liabilities with a relatively tiny risk budget – but the PPF is venturing in new directions nonetheless. “We are growing bigger and increasingly able to take investment decisions with all the advantages of scale,” says Clarke. “As we get larger, we are seeing more opportunity to diversify and secure first-mover advantage.”
The portfolio is split with 70 per cent in bonds and cash, 10 per cent global equity and 20 per cent alternatives. The cash and bonds allocation is divided between a collateral pool, which supports a derivatives program to hedge against interest rate and inflation risks, and return-seeking bonds. Here the allocation is in global sovereign and corporate debt, emerging markets and UK fixed income. The alternatives bucket includes what Clarke calls global tactics, comprising real estate (both UK and overseas), private equity, infrastructure and “alternative” credit. In this case, the strategy is to take advantage of the deleveraging of investment bank-balance sheets, including distressed debt. Similarly, the alternatives mandate now includes investing in assets from distressed sellers of private equity funds. In another departure, the PPF recently set an allocation to farmland and timber, with $100 million about to be invested in Australia and Brazil. It has appointed seven managers for these new mandates, including Brookfield Asset Management and Macquarie. “Some managers will be funded immediately, while others are appointed for deferred investment. All were appointed for four years, with the flexibility for two extensions of up to two years,” says Clarke.
In total the PPF uses 25 fund managers, which Clarke plans to increase to 30 throughout 2013, and strategy is managed by an inhouse team of 12. “Around 70 managers sit in a pool, we pull them off the bench, drawing upon them as and when,” he says. “Although we have a low tolerance to risk, not every mandate is low risk. Some of our mandates in the global tactics pool are positively volatile – we hold volatile and less volatile assets and the aggregate meets our tolerance for risk,” says Clarke, who confesses to having “spent a lifetime in insurance,” joining the PPF six years ago from the Co-operative Insurance Society.
Most allocations are active, although there are some passive mandates. “Our passive mandates tend to be in risk-adjusted benchmark funds. When we think the opportunity needs a particular skill, like private equity, we use an active strategy. Our allocations to alternatives also tend to be active.” Moulding the investment strategies of funds that come under its management is a gradual migration. “They don’t immediately transfer to the PPF; we do due diligence on the new scheme first.” This includes engaging with trustees to align strategies, introducing measures to hedge liabilities and reduce equity allocations.
Managing risk in the lifeboat
Within PPF’s modest 10-per-cent equity allocation, UK exposure is minimal so as not to double up on the fund’s existing exposure to UK economic risk. “If you look at the things that damage us as a business, it’s the insolvency of companies registered in the UK,” he says. “Hitching our investment strategy to the UK economy, when we are already exposed to UK corporate insolvencies on our balance sheet, would be a concentration of risk.”
It’s the flip side to the steady stream of stricken schemes’ assets landing in the PPF’s lap. Any sudden spike in offloaded pension liabilities, or the arrival of a particularly large corporate scheme, has the potential to sink the lifeboat fund. The PPF is also operating against a backdrop of deteriorating deficits in many of the 6000-odd schemes it potentially has to protect. The average UK scheme is only 80 per cent funded thanks to low interest rates at home hitting funding levels; recent PPF research puts the aggregate deficit of the schemes it could potentially have to cover at $386 billion. “Because of long bond yields, funding levels are now a lot worse than what they would have been three years ago,” says Clarke.
Fuelled by levies for now
The PPF charges the 6000 UK schemes eligible for its compensation should they go under premiums or levies in a process that nets around $950 million a year. So far it’s been enough to cover most – but not all – payouts, although it was frozen this year in response to corporate concerns during the recession. “The levy is still a large part of what is coming in,” admits Clarke. However, the PPF ultimately wants to be self-sufficient, drop the levy and rely solely on its own investment strategy for income.
The levy charged is particular to each scheme and set to reflect the risk that scheme represents to the PPF, gauging factors including the size of the scheme and the strength of the sponsor. “If the sponsor isn’t strong or the pension scheme is badly funded and our exposure is high, there will be a larger levy,” he says. The cost of the levy schemes have to pay the PPF is also set according to their own investment strategies. Schemes with large equity allocations and aggressive growth strategies pay a higher premium than those with more conservative strategies, with premiums oscillating to reflect different strategies by as much as 10 per cent. “We take a view like any insurer would. We don’t tell you what car to buy, but we will charge a higher premium if it’s a Ferrari,” says Clarke. It’s a cautionary mantra, skewed against risk, that the PPF will now apply to its ever-increasing asset base and investment clout.
