Overdoing the risk management

When we launched Life & Pensions three years ago, we chose for our first cover story to profile the UK's Pension Protection Fund (PPF), along with the newly created Pensions Regulator. With the ink of the legislation that created them barely dry, there were high hopes for the two institutions. Together they would stem the declining funding position of UK defined benefit (DB) pension funds, and prevent the scandalous loss of accumulated benefits that occurred under the previous regulatory system.

Three years on, the Pensions Regulator has shown it is serious about making DB scheme funding a necessity rather than a luxury for UK companies. The risk management sophistication shown by many trustees today would have been almost unthinkable three years ago. There have been some challenges, particularly the phenomenon of predatory pension buyouts driven by private equity, where the DWP has had to lend a hand.

For the PPF, the results are more mixed. Obviously, the existence of a pension lifeboat is a huge relief to individual DB scheme members, and in this sense the PPF has delivered. But among the schemes that pay the PPF a levy or insurance premium in return for its protection, there is a feeling of lowered expectations.

Granted extensive data-gathering powers, the PPF initially raised expectations by promising to charge pension schemes based on the risk they posed. Ordered to run itself on a self-financing basis, the PPF became obsessed with forecasting and replicating its cashflows. In August 2005, the PPF's chief executive Partha Dasgupta told Life & Pensions how he viewed the PPF as the tranche of a collateralised debt obligation (CDO) whose fair value was the amount it needed to raise.

It was an analogy designed to appeal to the financial intellectual elite, although perhaps ill-chosen in hindsight. Unfortunately, it soon became impossible to reconcile the PPF's overall funding requirements with a simple application of the levy at the individual scheme level. Given an incentive to improve funding and reduce credit risk, schemes did so. But this behaviour, along with improved data, played havoc with Dasgupta's number-crunching and the PPF was forced to increase its so-called 'levy scaling factor' by over 600% in three years.

The PPF may have raised the money the DWP told it to, but it has done so in a way that has alienated its stakeholders. Given that member schemes provide the PPF with its risk capital, one can imagine the questions of board governance that would arise if the PPF were a private sector company making similar unexpected demands of its shareholders.

And the volatility in premiums sits askance with the PPF's own extreme risk aversion, which resulted in an annual return of 1.95% up to March 2007. This may be a consequence of 'reducing the impact of unrewarded risks such as interest rates and inflation' (to quote the PPF's annual report) but the question must be asked: why should the PPF care about interest rate risk in the first place?

Corporate DB schemes whose sponsor could default at any time are right to worry about interest rates, because they determine the pension deficit which in turn measures the size of their day-to-day creditor exposure. It makes sense for trustees to use financial instruments to keep this exposure under control.

The PPF does not have a similar problem, because the UK government ultimately stands behind its liabilities. It could be argued that the PPF is more akin to a sovereign wealth fund or buffer fund which ought to be taking some long-term investment risk to minimise the levy cost imposed on its stakeholders. Like a teenager turned unhealthy from too much computer use, the PPF needs to get out more.