Stephen Wilcox explains how the PPF manages risks so it can protect millions of members of UK defined benefit pension schemes
The new challenges caused by COVID-19, which has left many businesses on the brink of survival and the global economy in a state of paralysis, put risk management procedures to the test. At the Pension Protection Fund (PPF) we use various tools to help us understand and manage our risks, both now and in the future.
The challenges of understanding balance sheet risks
The PPF is a UK statutory organisation that protects people with an eligible defined benefit (DB) pension if
their sponsoring employer becomes insolvent, providing compensation for their lost pensions. We’re not subject to financial services regulation and manage a balance sheet that, at the last accounting date (March 2019), amounted to £32bn of our own assets under management. We also estimated that a further £6.5bn of assets belonged to schemes that were going through our assessment period and were likely to transfer to our balance sheet. This makes the PPF one of the country’s largest providers of DB pensions.
Our role protecting members of UK DB pension schemes presents us with a unique set of risks, and claims are often unexpected and influenced by micro and macroeconomic situations. We cannot underwrite our risks, and every claim we receive has an impact on our balance sheet.
Our response to situations such as the current pandemic focuses on our long-term funding strategy. This is set out in the PPF Risk Appetite statement, which details that if our funding level changes significantly in the short term, we’ll ensure our response is consistent with our long-term funding strategy – rather than immediately responding to restore our funding level in the short term. This approach to risk is exclusive to the PPF, as we’re not required to adhere to any specific regulatory constraints.
The key aspect of our risk exposure, impacting our assets and liabilities, is the external and uncontrollable risk around claims. When a company suffers an insolvency event and its associated DB pension scheme has insufficient assets to pay its members at least what the PPF would pay, the scheme – including its assets and liabilities – will transfer into the PPF.
Our challenge is to understand how risks interact, for instance how the factors that affect our assets and our liabilities also affect the assets and liabilities of the schemes we protect. We also factor in the likelihood that scheme sponsors will fail, and think about what might happen if they do. All of this makes for a complex risk management operation.
At times like this, we need to juggle our understanding of inherent risk exposures with an estimate of how various government support schemes might change those exposures, and estimate how the assets of the schemes we protect might change in the most volatile asset markets any of us have encountered.
Working with TPR and understanding credit risk
We work with The Pensions Regulator (TPR) to better understand external risks and to minimise the impact when a scheme sponsor fails. This enables us to look ahead, so that we can understand where the risk of troubled scheme sponsors might come from. This collaborative approach is vital to ensure the best outcome for members of DB pension schemes.
Alongside our internal risk department, we also operate a standing credit risk group to analyse our exposures. This brings together experts from the risk department, actuarial financial management department, and restructuring and insolvency to talk about how businesses respond to stress and identify potential future claims.
For us, credit risk involves understanding the frequency of a claim (modelling the credit risk of a sponsor) and the size of a claim (using actuarial analysis of assets and liabilities). Engagement from this cross-departmental group ensures there is a common understanding of the risks we face across the organisation.
Four funding sources
While the PPF is a public corporation, we’re not funded by the government or taxpayer, and managing our balance sheet appropriately is critical if we are to deliver on our statutory obligations. Our funding strategy, which balances the risks of our four sources of funding – levy, scheme assets, recoveries from insolvent sponsors and investment income (see Figure 1) – works to ensure that, in the long term, there is a sufficiently high likelihood that we will be able to pay our liabilities as they fall due.
The annual levy paid by schemes eligible for PPF protection is substantially under our control. The levy is calculated based on the risk the scheme poses to us, and increases with the size of the risk.
The assets from the schemes we take on make up the largest proportion of our balance sheet and are fixed at the time of employer insolvency. Our recoveries from insolvent employers are dependent on the level of asset realisations and the quantum of creditor claims. Usually the pension scheme is an unsecured creditor, so recoveries will be paid out only after amounts due to secured creditors. During this process, our restructuring and insolvency team will work with stakeholders to actively manage recoveries and thus maximise value.
Once the assets are in our hands, the level of risk we run – and hence the expected return on our investments – is entirely under PPF control. We operate a strategy of actively hedging 100% of our inflation and interest rate risk using a mixture of bonds and swaps, which has served us extremely well over the years. The remainder of our asset portfolio is invested for capital growth. We invest globally in order to diversify away from the UK economy in which scheme sponsors operate, but the returns on our investments are highly dependent on economic circumstances.
Modelling the future
One of the most significant management tools we use to assess our finances is our Long-Term Risk Model (LTRM), based on the Monte Carlo simulation model. We run a million different scenarios to project what the future may look like under a range of economic, demographic and behavioural statistical distributions.
The LTRM helps us to measure progress against our funding target so that we can pay both our current and future members. Currently, our aim is to have a 90% probability of being at least 110% funded by 2030 (Figure 2). The 10% over-funding is intended to provide a buffer against demographic and operational risks – risks that are difficult or impossible to hedge cost-effectively.
This sort of modelling is most reliable when there is a clear baseline to project from and a clear understanding of future possibilities. At the moment we are in a position of radical uncertainty, where both the current situation and the possible future outcomes are very difficult to project.
We have two transformation projects underway, including transferring the LTRM to a modern platform used within the insurance industry for Solvency II. Upgrading the model will provide a robust foundation for our second important project: fully reviewing our funding strategy. As we get closer to 2030, we need to ensure we have the right strategy in place for the longer term.
The Purple Book and PPF 7800 Index
In order to inform our risk understanding – including both the credit risk analysis and the long-term modelling of the LTRM – we need good quality data about the schemes we protect. Each year we publish a data summary in The Purple Book, which helps us and the wider UK pensions industry understand the risks we’re exposed to, and promotes best practice in risk management.
The Purple Book provides the most comprehensive picture available of the risk profile of the DB pension schemes we protect. Its data helps us to identify and assess the risks to our objectives in an environment of significant uncertainty. The detailed breakdown covers scheme demographics, funding and information on historic claims on the PPF and the levies we receive.
When we first started reporting on the DB pension universe, there were 7,800 schemes. Over the years this has become smaller – more than 1,000 schemes have transferred into the PPF, while others have wound up. Today there are about 5,400 schemes we need to consider, as they could transfer to the PPF in the event of a company insolvency, and a significant number remain underfunded. Looking at the scheme deficits provides us with an estimate of the economic value that we protect.
Using The Purple Book data as a baseline, we are able to publish the PPF 7800 Index each month. The index is an official statistic and provides us with a monthly estimate of the aggregate funding position of the DB universe eligible for our protection. In our April 2020 update, the aggregate deficit was estimated to be £135.9bn at the end of March 2020, and nearly two-thirds of the universe is currently in deficit.
Operational risk is also extremely important to us. We encourage the schemes we protect to have contingency planning guidance in place that will mitigate operational risks to trustees, scheme members and the PPF in case their sponsors fail.
We need to ensure that we are also operationally resilient. Despite not being regulated, we adopt the Prudential Regulation Authority and Financial Conduct Authority guidance as best practice. These plans are regularly and robustly tested, and it’s been business as usual across the whole organisation since the prime minister announced people should work from home and avoid all unnecessary travel on 16 March – an example of risk management in action. We had a plan in place, which we implemented at pace and continue to evolve in response to changing circumstances.
We remain confident that our approach to risk management will ensure that we are well placed to meet our current and future obligations.
Stephen Wilcox is chief risk officer at the Pension Protection Fund