Ian Scott is head of investment strategy at the Pension Protection Fund
The Pension Protection Fund (PPF) protects the financial futures of members of UK defined benefit (DB) pension schemes. We currently protect close to 10 million people who we will compensate if their employer fails and their scheme is unable to pay them what they had been promised. Our investment mandate is to run a risk-controlled portfolio designed to ensure financial strength at times when others are facing difficulties.
This has been the case with our reserves growing to £9bn at the end of March, from £5.1bn in a year. Our reserves protect us against future claims. For context, despite many scheme funding levels improving over the past year, 2,383 DB schemes remained in deficit at the end of October, with an aggregate de cit of £109bn1.
This aggregated figure highlights the true risk that exists in the universe of schemes we protect. While our £9bn of reserves puts us in a strong position to face future challenges, many of the schemes we protect have substantial deficits which could, if they were to claim, have a material impact on our balance sheet.
A key part of our unique mandate is hedging all our on-balance sheet interest rate and inflation liabilities. In total, our liability driven investments make up around 40% of our assets under management. Once again, in an environment of heightened volatility and sharply higher inflation, the hedge has more than proved its worth. The regular re-balancing of our hedge means we are never too far away from our objective to be 100% hedged.
The remaining 60% of our assets are dedicated to making a return, so that we have the resources to cope with claims in the event of future DB sponsor bankruptcies. Our mandate here is to outperform our liabilities over the long run. To achieve this, our growth seeking assets need to make an annual return of 3.6%, with mandated risk of between 3% and 5%.
To achieve our investment target on our growth portfolio, we utilise a broad asset allocation, to benefit as much as possible from portfolio diversification – the closest thing to a free lunch in finance. Secondly, we hold a relatively large allocation (c.20%) in alternatives. Not only do alternatives promise some of the best risk-adjusted returns – especially infrastructure and timberland – but over time they o er a premium to compensate for illiquidity.
We approach some of the more conventional asset classes in a less conventional way. In global equities, we run against a minimum variance benchmark. This has a lower risk than conventional market weighted benchmarks and allows us to allocate more than would otherwise be the case. We chose our benchmark to avoid a pitfall of minimum variance investing – sensitivity to interest rates.
We also believe in active management, albeit within carefully constructed portfolios, and with as few systematic biases as possible. In emerging market debt, we utilise absolute return managers to limit our downside, while in our absolute return portfolio we seek out uncorrelated strategies, often operating in niche areas of the financial markets.
Our relatively high allocation to illiquid alternatives has meant that we have made extensive use of liquid alternatives (derivatives, ETFs and listed funds) to manage our asset allocation, and we have added to these portfolios as markets recovered.
Finally, we try to ensure our assets are not overly correlated with UK PLC, which is the source of most of our liabilities.
Our performance has been good despite market volatility. Last year was a record in our growth portfolio, with a return of 17.6%2. Of course, markets were favourable, but we more than exceeded our weighted asset class benchmark by 5.6%. More importantly, long-term performance has been ahead of target, with most of the outperformance coming from portfolio alpha rather than market beta. While investment performance has contributed to our balance sheet strength, we are not complacent.
In our view, markets are likely to be more challenging: returns are likely to be lower, interest rates higher and the return of inflation is starting to undermine some correlations and relationships. That said, we believe the key tenets of our approach remain valid and approach the next phase in the PPF’s journey in a strong financial position.
Notes
1) Source: PPF 7800 Index, October 2021
2) PPF Annual Report 2020/21
