The Secret CDO

With a combination of sophisticated derivatives engineering and down-to-earth policing, the Pension Protection Fund and the Pensions Regulator believe they can safeguard the UK's deficit-ridden occupational pension system

Partha Dasgupta, chief investment officer of the Pension Protection Fund (PPF), has a secret. The PPF, set up to safeguard the defined benefit pension schemes of insolvent UK employers, is at heart a giant synthetic collateralised debt obligation (CDO). This analysis might alarm most of the 12,000-odd companies covered by the PPF, for whom the concept of even treating a deficit as a financial liability is still a novelty.

"That's not how we'll articulate it to the pension world" Dasgupta concedes, "but as a financial model it's how we're thinking about these problems." Applying this sort of creative financial thinking, familiar to Dasgupta in his former role as managing director, fixed income, Europe at Barclays Global Investors, may spell the difference between success and failure for the PPF.

A creature of the UK's 2004 Pensions Act, the PPF took on its responsibility in May, along with its sister body, the Pensions Regulator, which replaced the old Occupational Pensions Regulatory Authority. At first sight the numbers are daunting. According to estimates, there are a total of £1 trillion UK occupational pensions liabilities, with a current total deficit of £70 billion. The PPF has not been short of critics, who have warned that a combination of moral hazard and a legacy of poor investment decision-making by UK pension schemes could doom the PPF from the start.

For the management of the PPF and the Pensions Regulator, the main line of defence against these pitfalls is summed up by the phrase 'risk-based'. The regulator uses its statutory powers to try and prevent vulnerable pension schemes and their sponsors from calling on the PPF in the first place; only in the event of insolvency does the PPF step in.

The PPF is intended to be self-financing, initially via a flat-rate levy paid by all schemes which has raised £150 million, and from April 2006 through the mechanism of a risk-based levy. Although the UK government at first estimated an annual levy of £300 million using 2003 data, more recent estimates put the total levy at £500-600 million. According to the PPF's proposals published in July, this levy will be based on two factors: the degree of scheme underfunding or deficit, and insolvency risk.

These factors led the PPF inescapably towards a CDO-type analysis, explains Dasgupta. "We've effectively got a long position in credit of 12,000 names, which is a basket portfolio," he says. "Effectively, it's a basket of credit default swaps (CDS), where the notional of the CDS is equal to the potential underfunding position of each pension scheme." In other words, for a single scheme with a fixed deficit, a CDS contract would replicate the PPF's position, paying the PPF an annual premium in return for its obligation to take on the net pension liability in the event of insolvency.

For an exposure to many schemes with uncertain deficits, the replication process becomes far more complex. The PPF is designed to take on multiple liabilities from a succession of bankrupt employers. However, with the vast amount of total liabilities in the UK occupational pensions system, the PPF would presumably be overwhelmed in the event of a general UK economic meltdown, at which point the risk would revert to taxpayers.

In the language of credit derivatives, the PPF has written protection on the first-loss tranche of a CDO, or as Dasgupta puts it: "It's effectively like an nth-to-default basket." Structured credit products of this type have been priced and traded by investment banks for some time, and the premium earned for selling protection of this type forms a market-consistent basis for the risk-based levy, as Dasgupta explains. "That's one aspect of technology that could be applied to try and help us forecast our liabilities. Obviously that notional underfunding amount translates into an underlying cashflow and you can then engineer a hedging portfolio."

Although this sort of thinking does not explicitly appear in the PPF's levy proposals, it is a key driver behind the levy calculation, says Dasgupta: "Quantitative structured credit models that are available are driven off underlying financial and transactional variables, and they can be used in a meaningful way to extrapolate from schemes where you have risk-neutral probabilities that you can observe from CDS. We'll go with more liquid names to form a sample and then extrapolate."

Extrapolation is unavoidable when applying CDO modelling to the PPF because of the variety of companies covered by the fund, as Dasgupta explains: "If we tranche our risk into large caps, publicly quoted companies, and the tail which are the small and medium-sized enterprises (SMEs), they have different characteristics. We can certainly use the CDS market to help us understand the large-cap part of the market. For the SMEs, they're difficult to individually model, so you have to make generic assumptions by industry or size. Where we have got information, we're trying to get the markets to price that for us."

There are other substantial challenges in attempting to calibrate the levy to the credit markets. CDS contracts typically have a maturity of five years, while the PPF's credit exposure to member companies extends far longer, as Dasgupta concedes. "Clearly from our perspective, we're charging an annual premium, and the protection extends out for the lifetime of the scheme, which could easily be 80 years depending how material the liability is. There's no-one in the financial or insurance markets who would ever take on that degree of term risk."

Because of these challenges, the PPF has decided, at least initially, not to explicitly reference the levy to market CDS spreads or other indicators such as credit scores or ratings. Instead, it has proposed to incorporate insolvency risk in its levy calculation using its own 10 risk bands.

However, a far bigger conceptual challenge is the pricing of the other risk factor found in the PPF's levy proposals: the level of scheme underfunding or deficit. On paper, this is straightforward, says Dasgupta. "The Pensions Act measures underfunding by the difference between liabilities, which are PPF benefits, and the market value of assets. So the starting point is that difference."

At first sight, it might seem sensible to restrict the levy to pension schemes in deficit because if an insolvency event occurred tomorrow, only these schemes would expose the PPF to a liability. However, not only would this be unfair on schemes that had de-risked themselves and were recovering from deficit, but it would ignore the hidden risks lurking in fully funded schemes, as Dasgupta points out: "If you're over 100% funded, it doesn't mean there's no chance of you ever having a claim on the PPF."

A structured approach

It is instructive to look at this problem in CDO terms. Focusing solely on schemes currently in deficit corresponds to modelling the PPF as a static basket of credits. In reality, schemes will migrate in and out of this basket over time as their funding position changes, in addition to migrations in sponsor credit quality. A crude way of modelling this is to assume that all fully funded schemes have a fixed probability of going into deficit in the future, and charge all these schemes for the risk of such a deficit.

Indeed, this is the solution adopted by the PPF by using two types of underfunding risk calculation. For schemes that are more than 105% funded, the levy will be based on 0.01% of scheme liabilities, multiplied by the sponsor credit risk factor. For schemes with a level of funding below this, the levy will be based on the maximum of 0.01% of liabilities and 1% of deficit, up to a cap of 3% of liabilities. The PPF has chosen a 105% funding cutoff rather than 100% to allow for deficit volatility during its assessment period.

While this will already strike most pension scheme trustees as quite complicated enough, the underfunding calculation arguably skirts round the most important issue of all: the investment risk of assets held by schemes. With the average UK scheme currently holding 65-70% of its assets in equities, a fully risk-based approach would charge proportionately for this market risk. Such an approach has been adopted by Dutch regulators under the FTK framework.

The collective exposure of UK schemes to equity markets amounts to a potent systematic risk factor to which the PPF is exposed. Given that default risk models for CDOs and bank loan portfolios typically include systematic risk factors that often take equity index prices as a proxy, the PPF could be dangerously overleveraged. By failing to charge properly for this risk at a time when equity markets are relatively benign, has the PPF wasted a precious opportunity?

Dasgupta has a carefully considered response to such arguments. As far as the PPF's own investment portfolio is concerned, he has avoided equities like the plague, in favour of a liability-matching portfolio of nominal and index-linked bonds. So shouldn't the PPF member schemes be encouraged to take the same medicine? "As far as introducing asset allocation into the levy, we want to introduce that as soon as possible, but in the right way," he says.

According to Dasgupta, immediately including investment risk in the levy along Dutch lines would be impractical for a number of reasons. The PPF wants to be seen as fair, simple and proportionate by the schemes it covers. But as Dasgupta freely admits, most UK pension schemes are currently years behind their Dutch counterparts in risk management terms. "I think that in the Netherlands, they are more professional and investment-savvy," he says. "They definitely have an advantage."

Here, Dasgupta highlights the twin structure of the UK framework, in which the Pensions Regulator's role is just as important as the PPF's. "The regulator is going to be introducing the scheme-funding objective later in the year, in line with the EU technical provisions. In doing that work, schemes will start to think about risk management issues. A lot of the knowledge and education that the regulator is promoting here in the UK will hopefully bring us up to the Dutch standard."

The eventual incorporation of investment risk is likely to follow the internal models framework of Basel II and Solvency II, Dasgupta explains. "We've proposed using a self-assessment approach in the same sense that banks and insurance companies use to assess capital adequacy," he says. "It's about modelling the volatility of assets relative to liabilities, to look at that over a number of timescales and confidence intervals, and then determine from that, what the adjustment to the levy premium should be for varying levels of risk."

Dasgupta is also mindful of the market consequences of forcing UK schemes to rapidly deleverage by switching from equities to bonds. "What's the likely impact and response on shareholders and boards of companies to that wholesale liquidation of UK plc? It's going to drive a lot of companies to the wall, resulting in insolvencies, which is going to increase the claims on the PPF." The solution, Dasgupta believes, is a measured approach allowing slow deleveraging over a 10-year period.

Meanwhile, Dasgupta is preparing for the time when the PPF will inherit its first pension scheme liabilities, along with their assets. He intends to be ruthless about sticking to his liability-driven investment benchmark. "We've mentioned derivatives in the statement of investment principles, and we are going to hedge risk," he says, accepting that this will vary widely from scheme to scheme.

In CDO language, Dasgupta wants to maximise recovery value. "We want to make sure that we have as much control as possible over the levels of claims that we might see. One way of doing that is to put some sort of overlay in place at the point that we become aware that the claim is coming into the PPF. So you would expect us to be using equity and bond derivatives," he says.

On patrol with the pensions police

If Partha Dasgupta plays the consummate technocrat, Richard Farr (right) comes across as a gruff English copper. As a manager in the corporate risk team at the Pensions Regulator, receiving eight to 10 clearance applications per week, he is very much at the sharp end, policing the behaviour of pension scheme sponsors. Underlying the Pensions Regulator's enforcement powers is the down-to-earth principle that pension schemes in deficit are creditors who have a right to protect their interests, as Farr explains: "We've not created anything new at all. There are already existing rights of material creditors, in law. All we've done is take existing market tools and solutions and applied them to trustees for the first time. They've been shocked, quite frankly, that they had these powers in the first place." An experienced insolvency practitioner on secondment from PricewaterhouseCoopers, Farr explains his approach: "There is a highly specialised marketplace of companies that go into turnaround or insolvency where people have honed their skills to try and either save companies or kill them cleanly. What I've done is take the skill-set from that area, and help the Pensions Regulator think more like an adviser to creditors." Woe betide corporate sponsors that become insolvent after ignoring the creditor rights of their pension scheme, says Farr. "It's like wrongful trading, which we took from the Insolvency Act." This applies to non-executive directors of companies as well, he points out. "It's personal liability." To protect themselves, companies must notify the Pensions Regulator before taking any action that might affect a scheme, hence the flood of clearance applications. The three big areas Farr looks at when examining an application are preference of payment, dividend policy and granting security. "Share buybacks are a massive case," explains Farr, "where you've got enough cash to pay the trustees but you choose to pay the shareholders. That's preference." While a major corporate event such as a takeover is likely to put trustees on their guard, the Pensions Regulator wants to protect them against less obvious events. For example, private equity buyers may finance a takeover using subordinated payment-in-kind (Pik) loans, which do not affect a pension scheme. However, two years later, the loan is quietly refinanced with secured bank debt, leaving the pension scheme unsecured. "Not a good result," Farr points out. But Farr does not want to say too much about what is acceptable or not. "The market is very clever at finding new rules that get around the rules," he says, "so we try to copy the takeover panel approach of issuing guidance and principles instead of rules. We might say, this transaction weakens the material position of a scheme. How do you define material? We'll give some guidance. But don't tell me that changing from an unsecured to a secured loan is not a deterioration."