Art by Dadu Shin
CIO: Bringing liability-driven investment (LDI) in-house is a big deal. Where is the Pension Protection Fund (PPF) now compared to when you first sat at your desk?
Trevor Welsh: When I started there were two parts: a systems project and an insourcing project. We had just changed our custodian as well, so it was quite a complex time. We installed BlackRock’s Aladdin system after a fairly extended period which is being used across the firm as a whole, and that has given us much greater depth and clarity of the LDI portfolio particularly, but other portfolios as well.
I liken it to a customer buying a second-hand car: Initially you might take a look under the bonnet and see if it looks clean; that’s where we were a year ago. Now we’ve got the full kit that we can plug in and see every single little detail about how the engine is performing. That was obviously essential for the second element of the project, insourcing, and key in terms of improving efficiency as we grow the fund.
CIO: What does that insourcing of LDI actually look like?
Welsh: A lot of my role has been around doing a deep analysis of all the LDI sub-portfolios that we have and the interactions with external managers—really knocking those into shape so that they’re in a good place going forward. Then came setting up the ability to insource, which went live at the beginning of October. We are now facing the market directly in certain parts of the LDI portfolio.
We used to have a number of portfolios where we were making investment decisions as opposed to the fund managers having discretion. But we had to issue direct instructions to the fund managers, and their dealing teams would go out and attempt to execute those in the market. Now we have effectively insourced that capacity. We are facing the market and dealing directly with banks ourselves on UK government bonds, UK fixed income, and inflation swaps. It’s taken a little while, but it has been a very successful introduction and I think everybody is comfortable with how it’s operating.
CIO: There has been a shift in the PPF’s derivatives strategy in the last few years. How has that transpired, and what effect has it had on the LDI portfolio?
Welsh: The PPF as an organization hedges out 100% of its interest rate and inflation risk in the LDI portfolio. Cash is split across LDI and a growth portfolio. A proportion of that cash is devoted to low-risk, low-volatility growth to improve and add diversification. What that means for LDI is that we need to apply a certain amount of leverage to get 100% hedged against interest rate and inflation risk. We use UK inflation swaps and interest-rate swaps to do that.
The complexity arose partly through fairly rapid growth and the scale of the derivatives we had. [The PPF has almost quadrupled in size in five years.] I wouldn’t say we were dealing in particularly complex instruments—it’s just the way the portfolio has grown up created a level of complexity that requires attention. Part of my ongoing role is to simplify the portfolio and the insourcing project is going to assist this greatly.
CIO: While you’re grappling with that, you’ve also got new derivatives rules to take into account, requiring you to post more collateral for swaps and trade them through central clearing houses. Is that going to be a problem?
Welsh: We are certainly fully engaged and have an ongoing project looking at the advantages, disadvantages, and operational aspects of clearing. That’s probably the next thing on our list for the LDI framework.
The rules offer some positive advantages but they also offer a fair amount of cost and there is a lot of complication involved with it. Ultimately, it seems to be coming down the pipe so we are preparing ourselves fully for it.
CIO: I don’t envy you—I’ve been reading up about derivatives recently and it’s given me a headache.
Welsh: It’s a bit like what Alan Greenspan said about the Federal Reserve: “If I turn out to be particularly clear, you’ve probably misunderstood what I've said.” Derivatives are a little bit like that.
CIO: The PPF might be insourcing, but your current bench of LDI providers don’t need to be too worried, do they?
Welsh: Exactly right. We’re certainly going to retain external management, and unlike other LDI funds, which are essentially closed and will ultimately shrink, the PPF is increasing in size. Even though we will insource a significant percentage, we’re still going to have a significant part of the LDI portfolio with external managers. We have a number of managers filling different roles such as hybrid bonds and infrastructure. The LDI managers we have are also managing other parts of the growth portfolio—they’re not just managing the LDI pockets.
Also, LDI management doesn’t actually pay much. From a profit-
and-loss perspective it’s probably reducing the managers’ workload a fair bit [if an LDI mandate is cut], but only reducing their revenue marginally, if at all.
CIO: You mentioned infrastructure. That’s playing an increasingly important role in many matching portfolios as traditional bonds get more expensive. How do you use it?
Welsh: What we tend to do here is look at all the cash flows, and if we have a real asset in the growth portfolio, we will mirror that asset using theoretical swaps. The inflation and interest rate characteristics of the real assets come into our LDI portfolio, and we exclude the credit element. This remains within the growth portfolio. Effectively this reduces the amount of gilts we need. The two very much tie in together.
CIO: Does this include assets such as the Danish abattoir you spoke about owning at our June Influential Investors’ Forum in London?
Welsh: This is a loan that we have made, secured against an asset, similar to our approach to infrastructure bonds, which have more definite cash flows—that’s where we would include the theoretical swaps. They have that sustainable income flow that is known over a particular period. We’re using our calculations to mirror the risk profile of the real asset. The LDI portfolio has a base layer from that, and we add everything on top to match the profile. We are building up a diverse mix of assets while being able to include the risk characteristics within the LDI framework.
CIO: Your LDI strategy is obviously adapting to reduce reliance on government bonds. Looking a few years down the line, what kinds of assets do you think will be making up your portfolio?
Welsh: I’m not sure the underlying assets will necessarily change that much. One thing we would continue to encourage the UK government to do—and have done fairly strenuously—is to introduce bonds linked to the consumer prices index [CPI]. That can then generate a market in CPI-linked derivatives.
The interesting thing about LDI is it is not static. It is particularly sensitive to changes in government policy and legal frameworks. We’ll continue to be buffeted by government policy, but I certainly don’t know what those changes will be! We will react at the appropriate time in the appropriate way. I don’t think you can rely on that as part of a de-risking exercise though; you have to make sure that your pension fund is in a good position. That gives you the ability to make rational, logical decisions extending into the future.