“I’m not really sure people understood what was really being created when the PPF was set up in April 2005,” Partha Dasgupta, chief executive officer of the Pension Protection Fund, told delegates at the recent National Association of Pension Funds investment conference, held in the Scottish capital of Edinburgh.

To help, he offers an analogy. Imagine a financial institution which has written a complex, time-varying £100bn (€124bn) derivative position on a basket of 21,000 names across a broad range of industries – many of them illiquid small and medium-sized enterprises – the value of which is linked to interest rates, equities, credit markets, currency, mortality and longevity (just for starters). Now imagine that those derivative contracts are both perpetual and irrevocable.

“You will have noticed the significant difficulties that Wall Street has had recently when it comes to pricing complex structures,” he observes. “It’s quite challenging for 160 people in East Croydon.”

The Pension Protection Fund is meant to guarantee retirement compensation for the 12m people in UK final-salary pension schemes. So far the assets and liabilities of 60 schemes with some 20,000 members, where sponsors have gone bust and schemes have not had enough money to meet PPF levels of compensation, have been transferred to the PPF’s balance sheet. More than 200 schemes with around 120,000 members are currently in the assessment period between going bust and transferal, which can last two-to-three years. Upon transferal, the PPF has to plug the aggregate deficit, and it does so partly through a mandatory levy charged on all UK final-salary pension schemes.

By March 2007, that meant that the PPF’s balance sheet showed assets worth £4.4bn (£800m from the levy and from schemes that had been transferred, and £3.6bn from schemes in assessment) and liabilities at £5bn (£500m already covered by the PPF and £4.5bn from schemes in assessment).

Already it can be seen that the PPF is exposed to the investment risk taken on by trustees of schemes in assessment. But that is positively dwarfed by its “off-balance sheet” exposure.

“The PPF is really two businesses,” says Mr Dasgupta. “The balance sheet represents an annuity business. But we are also an insurance business, and that is off-balance sheet: we’re underwriting the assets and liabilities for the 7800 pension schemes which currently pay the PPF levy.”

Last March, those assets were worth £817.3bn and the liabilities (calculated according to the PPF compensation levels and on a buyout basis) were £878.6bn, leaving an aggregate deficit of £61.3bn. “As recently as June last year, the aggregate surplus was just under £100bn,” Mr Dasgupta observes. “At the end of February, we unfortunately have an aggregate deficit of £100bn - given the degree of leverage we have to our off-balance sheet exposure, that is really quite frightening.”

Investment risk clearly influences the size of the levy that needs to be charged, so that volatility has opened up controversial questions about how the PPF’s levy should be set. Should the levy support a balance-sheet surplus at the PPF, to get it through periods of market volatility? How much investment risk comes from the PPF itself, and how much from the 7800 schemes it insures? And how much of the levy should reflect the risk that individual scheme sponsors and trustees implicitly run? Should well-funded schemes with de-risked portfolios be subsidising under-funded schemes with roll-the-dice investment strategies?

This is already accommodated to some extent, in that schemes that are 120 per cent funded pay a reduced levy and those that are 140 per cent funded pay none at all. But Mr Dasgupta says that these tapers - recently raised from 104 per cent and 125 per cent respectively - are “blunt instruments” and not up to the job of charging fairly in an environment of such volatile funding levels. For that reason, the questions above are likely to find their way into a consultation document due for publication in the summer.

Just how much risk is out there? Mr Dasgupta refers to the 2008 NAPF Annual Survey, which showed total assets in equities coming down from 59.7 per cent to 56.3 per cent, and fixed income coming down from 27.7 per cent to 29.4 per cent, but only 17 per cent of schemes using LDI and 53 per cent not even considering it as an option.

As part of its own research process, at the end of last year the PPF commissioned a survey from KPMG of the 95 largest pensions schemes in the UK, representing £191bn in assets. It found that 39 per cent of the UK pensions industry by value of assets only had up to 10 per cent of its liabilities hedged; and 76 per cent of those assets only had up to 30 per cent of liabilities hedged. Thirty-eight of the schemes used swaps, and of those, half did so via their active bond manager and only 12 used them specifically to hedge interest and inflation risks; of the remaining 57, just 28 have formally considered swaps for managing interest rate and inflation exposure.

“That suggests take up of risk-reduction in the marketplace has been a lot slower than a lot of people have believed,” says Mr Dasgupta. “There hasn’t been a headlong rush into liability-driven investment.”

How does that aggregated investment risk translate into the current, £675m levy? The credit risk of the sponsor companies accounts for £350m (45 per cent of these are sub-investment grade), and longevity risk adds £25m. With aggregate market risk assumed by the PPF and the 7800 pension schemes accounting for a massive £575m, that gives a gross levy of £950m. The diversity of these risks enables the PPF to net out £275m worth of levy, bringing us back down to £675m. According to PPF analysis, only £16m of the market risk element of the levy is down to the PPF’s own investment strategy – leaving £559m attributable to the risk taken on by the underwritten schemes.

The PPF’s investment strategy is evidently focused – as per its statutory duty - on meeting both the needs of levy-payers (to reduce incremental costs and the volatility of the levy) and of beneficiaries (to maintain funding of compensation).

“Simplistically, the PPF’s balance sheet has to be strong when the pension scheme finances are weak, and vice versa,” says Mr Dasgupta. “So in some sense our optimal strategy is the inverse to what everyone else is doing. Additionally, if you are underwriting 21,000 UK companies’ credit risk it makes sense to try and diversify your investment strategy away from UK credit to some degree.”

Because the PPF transitions assets from existing portfolios into its own (at the rate of around 220 schemes every three-to-four years), that is easier said than done: smart trading and efficient crossing helps keep costs down, but ultimately the PPF keeps as much of the schemes’ portfolios as it can and aims for low, rather than zero or negative correlation, with the off-balance sheet assets. There is a performance target of Libor + 1.4 per cent, and the risk budget, at 4 per cent, is about one-third of a typical UK pension fund.

Right now that results in a strategy focused on fixed income. “The PPF does not have a view on how much investment risk trustees and sponsors are happy to bear,” Mr Dasgupta clarifies. “That’s a decision that CFOs and trustees have to make themselves – and our job is to price that risk. But it’s important for everyone to understand the consequences of the aggregate decisions that have been taken across the UK’s pension schemes.”

Disregarding possible exogenous risk-reduction activity (such as the buyout market taking off), with a £675m levy and the current estimate of the investment risk in the system, the PPF has an 83 per cent chance of remaining fully-funded after 10 years, and a 79 per cent chance of being in surplus to the tune of £1 billion or more. But the chances of it falling into a deficit of £1 billion or more are 14 per cent. If you take investment risk out of the equation completely, the chances of ending up with that kind of deficit fall to just 2 per cent, and the PPF would be all but guaranteed to be fully-funded in 10 years, at 96 per cent.

Of course, eliminating risk is not possible, but managing risk and eliminating inappropriate risk is. The PPF looks set upon using its levy to incentivise schemes to be pro-active in this area - and penalise the laggards.

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