Super-PPF to the Rescue ?

There has been a welcome , if overdue, recognition by government that changes in the investment policies of UK defined benefit pension schemes over the last two decades have damaged the UK economy by massively reducing the asset allocation of DB schemes to higher return growth assets. The presumably unintended consequences of the accounting volatility triggered FRS17 and IAS19 have led to a seemingly inexorable increase in LDI investments in matching gilts and corporate debt as part of a de-risking journey to the promised land of buyout by an insurance company. The about turn in the conventional wisdom of pension fund investing since the equity-oriented days of Ross Goobey of Imperial Tobacco's pension fund has been actively encouraged by The Pensions Regulator (tPR). The latest tPR draft guidance seeks to mandate the new de-risking approach by limiting investments in growth assets once a scheme becomes significantly mature.

Nevertheless, policy-makers are at last realizing that what is rational to the trustees in terms of limiting risk for their particular pension scheme and potential exposure to a sponsor employer's creditworthiness does not make sense for pension schemes taken as a whole or the economy at large as UK firms are starved of a natural source of capital. Long-term investors such as Yale University's endowment or Canadian Pension Funds such as Ontario Teachers' Pension Plan believe in the virtues of a diversified portfolio of assets including significant allocations to alternatives where they can benefit from illiquidity premia. It is painfully clear that if all UK DB schemes had adopted this long-term growth investor approach , riding out shorter-term volatility, that pension funds as a whole would be better funded and the economy as a whole would have had more capital allocated to productive investment to make the nation wealthier. It is a classic case of mis-aligned incentives.

Prior to the 2008 financial crisis I worked at one of several competing teams trying to devise a cheaper de-risking fully liability-matched alternative to insurance buyouts which would have shifted DB pension pots to a separate vehicle. The new investing entity, benefiting from the non-accelerable leverage of deferred pension obligations, could then undertake these more sensible diversified long-term investment strategies underpinned by an infusion of external equity capital. The higher potential long-run returns would have allowed lower pricing compared to buyouts by insurance companies which are constrained by regulatory restrictions to invest in lower return, lower risk fixed income-type assets. The financial crisis torpedoed such structures.

The non-insurance concept has, however, re-emerged over 15 years later with new branding as the Pensions Superfund. Sadly in its new incarnation the term Superfund is a distortion of the english language akin to claiming that Hartlepool from League Three are really Premier League and Champions League winners Manchester City. In their quest to protect against any risks of failure tPR created rules which in effect impose limitations on the proportion of growth assets a Superfund can invest in. The limited prospects of attractive returns on equity coupled with a refusal to countenance actual dividend distributions to the equity investors have naturally acted as a disincentive to provide capital to the sector. Edmund Truell threw in the towel and mothballed his Pensions Superfund. Under current rules these are likely to have only a niche application for moderately under-funded schemes. To date there has been the grand total of one transaction (Clara Pensions for the Sears Retail Pension Scheme). It is unsurprising that the market prospects for the Pension Superfunds are limited. The closer the asset allocation of the Superfund is to that of an insurer the lower the difference in pricing between the two solutions.

Through the Mansion House reforms and yesterday's Autumn Statement the government is rightly seeking to get local government and private sector DB schemes to allocate more assets to alternatives and equities. It also hopes to move more smaller schemes into the Pension Protection Fund (PPF) which has demonstrated its competence over a long period in managing a diversified portfolio of assets (including of necessity a healthy allocation to growth assets given its role is to takeover underfunded schemes after employer insolvencies). In effect the PPF would become a Pension Superfund as a consolidator pursuing an investment policy that would be outside the scope of tPR's rules. Yet there is still scope for the PPF to do more and provide the missing piece of the jigsaw that would return the Pensions Superfund to its more radical roots as an industry-wide alternative to insurance buyouts which would allow more pension capital to be allocated to highly productive uses.

The PPF currently collects premia from all pension schemes through a risk-based levy to help it close the funding deficits it inherits when schemes are transferred to it. A Superfund structured as an occupational pension scheme without a economically significant sponsor employer would also qualify for PPF assessment in the unlikely event that its investment policies were to be spectacularly unsuccessful. The starting point , however, would be the injection of equity capital into the pensions system improving at the outset the chances of pensioners being paid in full. Therefore, it would make sense for the PPF to guarantee the obligations of the Superfund to its pension clients by charging an insurance premium. In effect the PPF would be paid a second time by charging a Superfund a premium for guaranteeing a risk - taking over a scheme of an insolvent employer - which it is already taking today with respect to the entire DB industry.

With a guarantee from the PPF there should be an exemption from the downside risk restrictions imposed by the tPR thereby allowing a growth oriented asset allocation policy by such non-PPF Superfunds. In effect, each Pension Superfund would negotiate a premium with the PPF which would vary depending on the proportion of growth assets in that Superfund's portfolio. Similarly the tPR restriction on dividend payouts by Superfunds should be dropped. The terms under which dividends could be paid would be negotiated between the PPF and a Superfund in the same manner that companies negotiate such matters with their bankers. This would help attract capital into Superfunds. For example, Edmund Truell would be tempted to remove the mothballs from his venture.

These very simple rule changes would not only provide funding for the PPF but through capitalist incentives turbo-charge a shift in the assets of DB schemes via Superfunds towards the longer-term diversified growth-oriented investment strategies that the country needs. And all this can be accomplished without imposing losses on pension scheme members.

What's not to like ?