PPF looks to hybrids

The Pension Protection Fund was set up nearly a decade ago to protect members of UK defined benefit pension where the sponsor became insolvent.More insurance provider than pension fund it’s risk tolerance is low and its investments conservative. But chief investment officer, Barry Kenneth, says the portfolio is evolving, including a new allocation to hybrids – assets that have both excess return and hedging properties.

The Pension Protection Fund’s main function is to provide compensation to members of eligible defined benefit pension schemes, when there is a qualifying insolvency event in relation to the employer, and where there are insufficient assets in the pension scheme to cover the Pension Protection Fund level of compensation.

It currently protects 6,000 schemes in the UK.

“Our risk tolerance is low risk compared to the industry and we have a global investment strategy so that we don’t correlate to the schemes we underwrite or the UK economy. It’s why we have a large allocation to alternatives and offshore assets.” Kenneth says. “The return driver comes out of the risk tolerance and we model probability of that. We want the probability of success greater than 80 per cent.”

“At the end of the day we’re a deferred annuity provider, given that we are a pensions provider of last resort to qualifying defined benefit schemes. We fall somewhere between a pension fund an insurance provider, and probably more the latter.”

The PPF has a conservative investment approach in line with a return objective of 1.8 per over liabilities with a strategic risk budget of 4 per cent. Importantly there has been a recent evolution of this risk budget, as the fund has added illiquidity as a separate risk factor.

“Given the PPF will pay compensation over a long timeframe, we concluded that there should be a tolerance to have more illiquid assets, although it was paramount we could demonstrate to the Board, that we could quantify that risk and also ensure we are compensated accordingly for tying up capital.”

“As we develop our asset allocation to include assets which have growth and hedging characteristics, many of these assets tend to be more illiquid (e.g. property leases) so being able to quantify all the risk factors from these types of assets is important. A portfolio of swaps, bonds and cash is applied to the portfolio as a swap overlay to mimic the expected liability cashflows.”

Outside UK government bonds, the bond portfolio also contains emerging market debt, investment grade credit, ABS and global sovereign bonds.

The fund is relatively new to alternatives, with this strand of the investment strategy being adopted in 2010, including private equity, infrastructure, real estate, GTA, farmland and timberland and alternative credit.

There will be a larger allocation to what would have been classed as alternative assets in the hybrid allocation as some alternatives such as debt infrastructure or property leases will form part of this portfolio and these assets have both return characteristics as well as stable long term cash flows which assists in hedging the liabilities.

Under the new target allocation the biggest shift will be from cash and bonds to the new hybrid allocation, which will be around 12 per cent, which will result in the deployment of £2.5 billion to £3 billion in this area.

“It is difficult to get these assets, and valuations are high so we figuring out what a realistic allocation might be. We think of them in terms of risk factors, not what the assets are called, it needs to fit both in both the growth and hedging criteria.”

The fund’s hedging portfolio is made up of 30 per cent gilts and 70 per cent over the counter derivatives and will now also include hybrids, which will have liability and asset qualities, marking the key evolution in the portfolio in recent times.

“You can have classification of assets but in the hybrid book the risk factors are more important than the name, so we will be looking for factors such as duration, inflation, credit, illiquidity. Whether that derived from UK corporate bonds, ground rents, leases, social housing is not the main driver it’s the factors,” Kenneth says. “When we think about liquidity/illiquidity in terms of modelling that factor, our driver is how long it takes to sell that asset as close to fair value. For example gilts or listed equities model as having no illiquidity premium as they can be sold on the same day, however if we hold a property lease that would take months if not years to realise fair value. In the context of the fund we need liquidity to pay collateral on derivative positions and to pay our member compensation. In terms of sizing our illiquid assets we are conscious that our liquidity needs are not compromised by allocating more capital to illiquids.”

The fund protects 11 million members in defined benefit schemes across the UK and has about £16 billion in assets.

Kenneth says there are a number of challenges facing the fund in the next couple of years including those associated with using over the counter derivatives. The cost of hedging will go up as central clearing becomes a requirement and bank’s ability to warehouse risk becomes more challenged, through new financial regulations.

“We also worry about the provision of balance sheet from banks on operations such as Repo, given the new bank leverage rules, which we use in our strategy. We therefore need to prepare ourselves for that in terms of buying more assets which give us long term cash flows and have less reliance on derivatives. Banks retreating in certain lines of business could also give us an opportunity to plug gaps where we think there is value i.e. direct lending. This is why we are creating the hybrid bucket.”

“We will have to evolve the way we interact and deal with banks and we are looking at how we can evolve our strategy without getting too hamstrung by additional costs.” “Given our size we can play in more areas, for example property leases and we can we be a material player. Our size is giving us flexibility and we need to use that to become more efficient.”

Kenneth, who has a team of 12, will be recruiting to evolve the team to deal with the growing complexity.

The PPF is also in the middle of a risk system procurement, in order to provide more portfolio information. It is also conducting an emerging markets debt tender. The fund has funded about 30 managers, with a current pool of about 60.

And while everything is managed externally now, one of the agenda items of the next three-year business plan is whether to internalise any investment functions. The fund was 109 per cent funded last year, achieved through investment returns and a levy on the industry of £695 million a year. To be protected by the PPF, a fund has to have a sponsoring corporate that is insolvent and the pension fund has to be underfunded.

“We get claims every year from funds that are underfunded. We charge each fund based on the risk of the scheme and the number of members. Our mission by 2030 is to be self-sufficient.”