Press Release on Pension Protection Fund investment principles

by Dr. Ros Altmann

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PENSION PROTECTION FUND STATEMENT OF INVESTMENT PRINCIPLES

1. Important for trustees to recognise that PPF asset allocation does not represent a ‘model’ for UK pension funds
2. Trustees should not think 70% cash and bonds/30% equities and property is appropriate for their own funds
3. PPF liability profile very different from ‘typical’ UK pension fund
4. PPF is just demonstrating the broad principles of a liability-driven approach
5. Trustees should take care to ensure diversification and downside protection
6. Trustees should focus on risk budgeting and taking risks they expect to be rewarded for
7. Use of swaps and currency overlay important for trustees to consider
8. One concern with the proposed allocation is that PPF will rely on ‘enhanced indexation’ this seems sub-optimal and may entail more risk.  It might be more efficient to use a passive core of indexed funds (for market beta)  plus long-short or absolute return managers to add manager skill returns (alpha)

The PPF has just released its latest Statement of Investment Principles.  It is important for pension fund trustees to understand the broad principles which the PPF believes are important for pension funds, but that the PPF’s asset allocation is not meant to be a model for UK pension funds.  The important broad principles for trustees to consider are:

1. Asset allocation relative to their own liability profile
2. Careful risk budgeting
3. Using modern methods of money management to control ‘unrewarded’ risks
4. Using options and overlays for downside protection
5. Hedging currency risks of overseas holdings and using currency overlay

The actual asset distribution specified in the PPF SIP – 70% cash and bonds, 20% equities, 10% property and currency – is not appropriate for most trustees to adopt.  The PPF liability profile is very different from that of a typical pension fund because:

1. PPF risk highest when UK insolvency rate highest (falling UK equities, rising yields)
2. PPF risk highest when UK aggregate pension deficits rising (falling global equities, falling UK yields, rising mortality)
3. PPF will be taking over assets from failed pension schemes
4. PPF liabilities have less inflation linking, are capped and can be reduced

The PPF is leading the way for pension fund trustees to think clearly about managing their asset allocation to explicitly take account of their liability profile.  It is also highlighting the importance of diversification and downside protection.

To sum up, there are many good elements of this PPF announcement, which include:

Good points for trustees to note:

1. Liability driven asset allocation – targeting 1.4% outperformance of the liability benchmark – (which is a notional zero coupon bond of the expected future cash flows of the PPF)
2. Important to control downside risk
3. Use inflation and interest rate swaps as a liability-driven overlay
4. Try to only take risks expect to be rewarded for – reduce impact of unrewarded risks such as interest rates, inflation, currency
5. Diversification to enhance returns

There are some elements that are a little disappointing however:

1. It is unclear why all the equity exposure is with long only active managers

2. There is no passive core and no long-short hedge funds or absolute return managers, which means all the active management will probably be with managers who deviate very little from the index (‘enhanced indexation’) and the evidence suggests little likelihood of consistent outperformance relative to a passive manager.  It will also be more difficult to use options to protect downside risk because the portfolios will not be replicating the market itself and will carry far more stock-specific risk, whereas having a core exposure to indexed equities would allow better downside risk control

3. Most of the equities taken into the PPF from failed funds will probably be UK long only actively managed.  This would suggest to me that perhaps the PPF should have had a preference for emphasising overseas markets, to reduce the correlation with UK equity market downturns which are high risk periods for the PPF (again using a combination of long-short equity hedge funds, with a core position of global ‘index tracking’ funds).

ENDS

Ros Altmann is an independent adviser on pensions policy.

Notes:

In the past, UK pension funds have invested heavily in UK and overseas equities, relying on ‘expected’ stock market returns being high enough to enable the funds to meet all their pension liabilities, without recognising properly that their liabilities are heavily dependent on inflation, interest rates and mortality, which may not be matched by equity performance.  Therefore, if the ‘expected’ returns did not materialise, or if the liabilities increased by more than forecast (due, for example, to changes in interest rates, inflation or mortality) there was no protection against bad outcomes.

What the PPF is highlighting is the need to think carefully about the overall risk budget and how to use it, with protection of the downside and diversification providing enhanced returns and lower risk than just relying on equity markets to perform strongly.

The PPF is recognising the need to protect against risks that trustees do not expect to be rewarded for.  Equity markets carry two kinds of risk – the risk associated with volatility of company performance (expect to be rewarded for this risk over time) and also the risk that equities will underperform bond markets, inflation and mortality (do not expect to be rewarded for this risk).  Global equities and bonds also carry currency risks which would just be a by-product of the equity market exposures, so it makes sense to hedge these back into sterling and take currency risk with an overlay manager, who would expect to deliver added value from exploiting the inefficiencies in currency markets.

The PPF is adopting careful risk budgeting, looking at a 4% active risk budget (which is about one third of the active risk of the average pension fund).  It needs to take risk because it is already in deficit and cannot rely on just ‘matching’ its liabilities – it needs to outperform them.  It is seeking to gain the outperformance from active management of equities and currencies, from diversification of investments while also protecting the downside against a worsening of its deficit.