Trevor Welsh, the UK’s Pension Protection Fund’s head of liability-driven investment, discusses how it manages interest rate and inflation risk. Interview by Carlo Svaluto Moreolo


  • Assets: £23.4bn (€29.8bn)
  • Investment return: 1.7%
  • Funding level: 116.3%
  • Members protected: 11m
  • Likelihood of self-sufficiency by 2030: 93%

Carlo Svaluto Moreolo What did your insourcing project involve?

Trevor Welsh We transferred a first tranche of assets to in-house management at the beginning of October 2016 and the second tranche followed in December. The transition involved transforming mandates. It involved implementing the BlackRock Aladdin system as our omnibus because it covers trading, settlement and risk management. 

We feel it has been successful. It was done on time and on budget, thanks to an effort that brought investment, operations, risk and IT teams together. 

Since then, we have run the portfolio according to strategy. We have also strengthened the relationships with our bank counterparties. 

 Has the LDI strategy changed as a result?

TW The project did not change our philosophy on LDI. We have a policy of hedging 100% of interest rate and inflation risk. If anything, by insourcing we’ve reinforced our strategy. The insourcing was about control and efficiency gains. We have changed operationally how we control the process, to allow us to develop it and respond to new regulation in an efficient manner. 

What about the LDI portfolio that was left with external managers?

trevor welsh

TW We have maintained some externally-managed passive interest rates and inflation-rate swap overlays positionings. We are keeping these stable. Most of the dynamic hedging we take care of in-house, as our benchmark is active. We’ve allowed the external benchmarks to remain more stable, rather than having to change it on a regular basis. 

Under the European Market Infrastructure Regulation (EMIR), pension funds are still exempt from central clearing of over-the-counter (OTC) derivatives. Did the PPF plan for central clearing, when swaps management moved in-house?

TW As we were insourcing, we wanted a structure of portfolios that would consider changes in regulation. The balance between assets and derivatives has changed, as well as how we operate in terms of leverage. That has been key within the LDI portfolio itself. 

Furthermore, all pension funds and asset managers are aware that the use of margining in derivatives is going to require more resources. We looked at the whole portfolio, both growth and matching assets, to consider what the optimal structure should be, and where risk should be allocated. This is to take account of the fact that we will need to hold more cash within the portfolio for initial and variation margin on OTC derivatives. That work was undertaken last year and we are analysing the results and looking to implement that best strategy. 

There are further transitions and transformations to come, but we have time on our side in order to progress that. Everything we are doing is in awareness that changes in regulation are possible. 

CSM In the past, the PPF signalled that it was integrating non-traditional LDI assets within its hedge. Is that still part of your strategy?

TW We have continued to progress towards building less liquid assets in the portfolio. We are looking at asset classes with defined cashflows such as infrastructure. We then looked at the LDI and risk elements of those, and build those into our overall hedge. We stripped out the credit carry element of the assets, but look at their sensitivities to changes in interest rates and inflation, modelling those using synthetic instruments.  

Where we deem an asset has matching characteristics, we aim to fully include those aspects into the overall LDI hedge, and then build Gilt and swap-based LDI asset overlays around those matches. Currently, we have a portfolio of illiquid assets, and the hedging characteristics of that portfolio are included in the overall hedge. We expect that to continue to grow.

In that portfolio, we hold dual-purpose assets. These are investments that carry a complexity or an illiquidity premia, or assets with defined cashflows that offer a spread over LIBOR. These form part of the growth element of the portfolio, because they have that spread and matching characteristics. It would be inefficient to just ignore those characteristics and treat them purely as growth assets. So we look at how we model that risk appropriately and include that risk within our overall hedged profile. We like these assets, because they match our requirements both from a growth and a matching perspective.

CSM What do you see as the biggest challenges for your LDI strategy?

TW We have seen a trend of pension schemes trying to shift from derivatives towards Gilt-based benchmarks. This is for a number of reasons, not least bank regulation, which made swap valuation and liquidity more challenging. For the PPF, which has a relatively dynamic benchmark, those issues are key. It is paramount to transact at prices and levels close to your valuation. We have been part of that trend, and are trying to rely more on physical assets. We expect this trend will continue in the short term. It is taking the evolution of all the derivatives markets into account. 

We have developed the way we manage leverage, and that is a benefit of insourcing, in that we have more control over where we utilise our leverage requirements. The insourcing allows us to control our destiny more efficiently. 

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