PPF levy dilemma for small schemes

The inclusion of investment risk in the PPF’s levy calculations from 2012-13– confirmed on Monday – has been widely welcomed by the industry.

But schemes with less than £1.5bn in liabilities who make use of derivative overlays or liability-driven investment (LDI) strategies will have to pay additional costs to have their less risky strategies factored into their levy calculation.

Such schemes will need to weigh up whether it would be worth the additional costs to undertake voluntary certification, or to carry on paying a levy which would not take into account their risk-mitigating investments.

In addition, they need to decide whether to reduce their exposure to assets in their overall investment strategy, in order to reduce their investment risk as designed by the PPF and save money on levies.

“For such schemes, the proposals may present an added cost dilemma – whether to undertake voluntary certification, in order to reduce their levies,” said John Belgrove, principal investment consultant at Aon Hewitt.

He added: “Similarly, many pooled funds that have strong, even geared, embedded risk mitigation may not receive appropriate credit in standard risk tests.

“Again, trustees and sponsors may need to think about the cost-benefit decision for providing information to meet bespoke stress tests.”

The vast majority of defined benefit (DB) schemes have less than £1.5bn in liabilities and an increasing number have adopted LDI strategies in the past decade.

2012-13 levy structure

The new framework, first proposed last October, takes into account the investments held by each scheme, which the PPF collects from the Pensions Regulator’s Exchange system.

The PPF then applies a stress test to the assets according to how risky they are, which was developed by the consultant Redington.

Under the standardised test, which applies to all schemes smaller than £1.5bn in liabilities, UK equities are stressed to -22%, with overseas equities stressed to -19%.

This would lead to schemes holding a higher proportion of equities facing a costlier levy.

But index-linked bonds would be stressed to +16% and annuities +12%. This means schemes holding higher proportions of less risky assets will be rewarded with lower levy payments.

The stresses will be updated before implementation.

“It clearly makes sense to factor in investment risk, provided it can be quantified in a sensible way,” said Steve Mingle, director at Isinglass Consulting and former group pensions director at Diageo.

“It looks as though they have tried to strike a balance between an approach which has a sound theoretical grounding with something fairly practical to operate.”

But he added: “All sponsors will have to accept there will be anomalies – perceived if not actual – but this is the case for the existing levy basis in any event.”

Bespoke testing

The 100 or so DB schemes with £1.5bn or more in liabilities will be subject to a bespoke analysis.

The PPF proposes these schemes use their portfolio information as at their latest annual accounts date, and apply stress testing to the assets.

The bespoke calculation would come in two stages. First, the scheme’s assets are stress tested in 20 sub classes, which reflect the more complex investment strategies used by larger schemes.

The second stage applies to schemes with investments in derivatives either directly or through pooled LDI funds.

This means schemes which have hedged against inflation and credit risk will be rewarded with lower levy payments.

Schemes smaller than £1.5bn in liabilities can request to take bespoke testing, but this would incur additional costs and they would have to work out whether the cost of doing so would be worth the reduction in their levy payments.

Reducing risk

Belgrove said the investment risk element in the new levy framework was welcome and was a reason to encourage schemes to derisk their investments.

“Without factoring investment risk, it’s like charging all diners at a restaurant an equal share of the total bill without taking account of what they have ordered,” he said.

Belgrove said schemes considering derisking in order to reduce their levy should first sit down to work out their long-term goals and whether a derisking strategy would be appropriate.

But Martin Clarke, executive director of financial risk at the PPF, told schemeXpert.com the fund was not trying to change scheme’s investment decisions.

“What we are trying to do is reflect the fact that the schemes which come into the PPF in stressed conditions will tend to have very large deficits and those deficits will depend on the investment strategy that the scheme adopts,” he said.

“We are trying to reflect appropriate levels of levy to the circumstances of each individual scheme. We are not making investment decisions for them.”