• Size of Scheme
  • Small funds - insurance contracts
    • costs and difficulties with admin and legal aspects outweigh investment considerations
  • Larger funds - consider other alternatives to IC
    • take responsibility for administration and investments
  • Few pension schemes employ their own staff to manager their assets

Funding Level

• Surplus 
  • scope to follow higher risk/return strategy - little value in this 
  • Aim to have small surplus
  • Cushion unexpected funding shortfalls, or pay discretionary benefits - expand on this
  • Large surplus may be refunded to Scheme's sponsor less tax charges
• Balance or Deficit
  • asset allocation strategy closely matched to liabilities along with return seeking investments to close funding gap
  • risks of strategy need to be accounted for
  • small deficit isn't problematic - absorbed by additional contributions
  • large and growing - negative impact on balance sheet; cont levels increased significantly; member disquiet; increased regulatory scrutiny

Strength of Employer's Covenant

• is the employer's ability to meet funding obligations and met them when investment performance poor
• T's aim to quantify Critical funding level, below which a shortfall becomes financially unmanageable
• number of companies now offer covenant assessment services

• Size of scheme relative to company
• Sponsor's credit rating
• Sponsor's maximum contribution level
• Market events that could lead to such a situation, (equity falls, interest rate falls, inflation expectation increases, demographic events)

• Regulation and Legislation
• Employer and Trustee Attitude to Risk
• Cash Flow Requirements
• Liability Profile

• No. of significant developments in recent years
• Changes to pension fund accounting regulations have placed liabilities under far greater scrutiny than in the past
  • Small differences in discount rate -> large effect on L and Funding levels
• Regulator - PA04
  • To counteract underfunding seen in dotcom burst
  • power to intercede in schemes that have underfunding issues
• PPF
  • solution to seriously underfunded schemes whose empoyer is insolvent
• TKU requirements
  • scheme documentation; pension and trust law; funding principles of OPS; investment of assets
  • must ask for professional advice on matters they don't understand and on technical issues which may affect the scheme
  • obliged to ensure investments are contributing to deficit reduction and meaningfully improved funding positions in the future

• Trustees do not need to follow the employer's instructions when setting investment policy, but they need to consider their attitude to risk.
• Answer following questions:
  • Stable conts wherever possible?
  • Upper limit to conts?
  • If it had to exceed this level, what action would the employer take?
  • Effect investment policy has on accounts?
  • willing to take on risk of mismatching policy - lower long term costs but risk of greater conts from time to time.
• T's must not act in a way that jeopardises the security of members' benefits
  • mustn't embark on policy involving more than the minimum degree of risk unless they have employer's financial backing

• Contributions exceed benefit outgoings - younger schemes
  • benefits paid from conts before passing to investment manager
• Other schemes - conts supplemented by investment income to meet benefit outgoings
  • high proportion of pensioners
  • contribution reduction/holiday
  • T's need to hold investments which generate a certain level of income -> expand
• Particularly mature schemes
  • May need to sell investments
  • Careful planning required
  • Managers informed in advance - planned programme of selling

• Liabilities are a stream of current or future cash payments required to fulfil the pension promise
• Cash flow profile comparable to bonds but in reverse
• Bonds - regular predictable stream of future income payments
• Liabilities - regular and more or less predictable stream of payouts
• PF's require assets that provide a cash flow profile similar to that of its liabilities
• Liability profile can be constructed by modelling each projected cash flow as a series of financial instruments that capture both the timing and sensitivity of the liabilities.

• T's need to know how much money a fund should contain today to fulfil pension promises
• Valuation is a complex task
  • assets subject to market fluctuations
  • Liabilities - life expectancy and inflation
  • PV of L - assumption of discount rate
    • rate of return on assets from now until R
    • Lower DR = larger PV of L 
• MFR
  • First step - 1997
  • Assets measured at market value
  • L - current unit method:  members accrued service not including future pay rises
  • DR - actuary's assessment of long term returns on assets
  • specified a minimum level of assets
  • Shortfalls corrected within prescribed timescales
• FRS17
  • 2000, full effect 2005
  • Common accounting standards requiring pension scheme assets/liabilities to be included in balance sheet
  • Assets measured at fair value
    • quoted securities - mid market value
    • unquoted - estimate
    • Propery - open market value
  • Liabilities - projected unit method, discounted using current rate of AA rated bond of equivalent term and currency to liability
• Scheme Specific Funding Requirement
  • PA04 - 2005 
  • Rather than common funding measure, allows schemes to take account of individual circumstances of the scheme.
  • SFO - have sufficient assets to cover provisions
  • Trustees decide upon actuarial methods and assumptions to be used after obtaining advice

LDI

Intro

Key Components of LDI Strategy

• Places liabilities at the heart of investment strategy
• Aims to deliver a significant improvement in scheme's risk/return characteristics compared with traditional 
• Based on principle that the ultimate benchmark is its projected cash flows (future liabilities)

Components

• Match liabilities
  • Core portfolio designed to replicate profile of liabilties 
  • replicate sensitivities:  interest rates and inflation
  • Built from combination of bonds (fixed and index-linked) and swaps (interest and inflation)
  • Swaps enable a more effective liability-matching and can be used on a non-intrusive basis - swap overlay
• generate growth
  • invest across diversified asset classes
  • can also be adjusted to mirror sensitivities through swap overlay
  • Prudent to aim to be overfunded to avoid future shortfalls as a result of changing projections (e.g. mortality)

• aims to minimise unrewarded and unintended risk
• traditional:
  • high exposure to to equities leaving schemes open to variety of risks:  fund manager; stock markets; interest rates; inflation and longevity
• Main risks to pension fund come from interest and inflation
• active investment risk taken in the context of the return a scheme needs to meet its liabilities rather than tarketing a market index that has little relevance to a scheme's liability profile.
• Amount of active risk taken will vary from scheme to scheme reflecting:
  • Liability profiles
  • funding positions
  • appetite for risk
  • strength of sponsoring employer
• returns above a certain level may not add sufficient value to justify the additional risk involved

LDI is suitable to all DB schemes as their main objective is to meet their liabilities:

·         Pooled LDI solutions now allow smaller schemes to benefit

·         Defining the LDI benchmark for a pooled client is exactly the same as for a segregated mandate

o   Difference being that a smaller client’s portfolio will comprise a unique combination of pooled components

o   There are a sufficiently comprehensive number of pooled funds available to enable a very precise liability match

o   Can be combined with return seeking component.

LDI is suitable for all funding levels:

·         Use of swaps allow underfunded schemes to manage a greater proportion of interest rate and inflation exposure than would be possible on a fully funded basis

·         LDI may also be employed to protect a funding surplus by ensuring that the underlying investments are appropriately aligned to meeting future liabilities.

LDI is a solution based approach to investing, as opposed to an off the shelf product.

Asset Allocation

Strategic (5)

Tactical (5)

• Strategic Asset Allocation
  • Suitability of different asset types to meet liabilities
  • UK skewed towards equities, Europe skewed towards bonds
  • risks associated with high weightings in equities was highlighted after dotcom crash
  • Changes in regulation have aimed to address the lack of focus on liabilities - more responsibility on trustees KU to make relevant decisions
  • Policy regarding strategic asset allocation decisions has to be included in SIP
• Tactical Asset Allocation
  • Day-to-day management of the portfolio's asset mix
  • delegated to investment managers
  • Tactical decisions can be made to deviate from long term asset mix to take advantage of short term investment opportunities
  • Changes in economic conditions can lead to a short term underperformance or outperformance of one asset class over the other - take advantage by changing asset mix
  • T's provide instructions via IPID

• Risk budgets raise the issue of how much investment risk to take and where in order to reach the desired funding outcome and ensure that at least the critical funding level is always achieved
• Risk budgets ensure that trustees take into account both the potential upside and downside of investment policies
• Quantifying the critical funding level

Notes on the SIP

(not including what the SIP must include)

• Sets out the principles governing the investment strategy, i.e. how decisions must be made.
• Not needed for insured schemes that only hold one investment, the insurance policy
• Before a SIP is drawn up, the trustees must:
  • obtain and consider advice from a person who they reasonably believe to have appropriate knowledge and experience of financial matters and investment management
  • Consult with the employer - considering their views
• SIP should be reviewed at least once every 3 years and whenever there is a significant change in investment policy
• If trustees fail to comply with requirements, they may be prohibited to act as trustees or face civil penalties
• IPID contains details regarding the day-to-day management of the investment strategy

• Responsibilities for investment decisions
• Investment Objectives
• Asset Allocation Strategy
• Investment Mandates
• Risk Management and Measurement
• Fee Structures
• Socially Responsible Investment
• Corporate Governance

• Effective Decision Making
• Clear Objectives
• Asset Allocation
• Expert Advice
• Explicit Mandates
• Activism
• Appropriate Benchmarks
• Performance Measurement

Myners' Updated

• 2004
• Many trustee boards had not attained the skills and expertise needed to achieve improvements in investment decision making.
• TKU requirements introduced in Pensions Act 2004
• Suggested admendments by myners:
  • Chair of trustee board should be responsible for ensuring the board as a whole has sufficient skills and expertise
  • Large funds should have access to in house investment expertise
  • Large funds should adhere to requirement of chairman and one third of trustees should be familiar with investment issues.

How do trustees determine/implement a new investment strategy

• Objectives and aims
  • may face conflicts or contradictions and may need to make compromises
• Asset Allocation Strategy
  • make use of asset liability study - projection of different strategies and their impact on the finances of the scheme
• Investment Structure (managers and type of products)
• Performance Targets

DC Schemes

Intro

• Fast growing area of pension investment
• Money purchase
• Employees and employers make regular contributions to an investment fund at a defined proportion of the employee's salary
• Payments build up a 'pot' of money which can then be used to buy an annuity
• Pot depends an amount paid in and success of investments
• Members hold burden of risk
• Consists of separate pension portfolios for every member and it's the T's responsibility to ensure that a sufficiently broad range of investment funds is on offer

Range of Funds

• Cater for different risk profiles:
  • Actively or passively managed equity funds
  • commercial property funds
  • Bond Funds
  • Balanced Managed Fund
• T's have responsibility to offer enough propective funds to provide a wide choice for members but not so many that they would have difficulty in selecting
• Stakeholder pensions
  • personal plans most suitable for self employed
  • low cost, flexible and secure
  • Employers with 5 or more staff are required to offer employers a chance to join a pension scheme - must provide access to stakeholder
  • Minimum standards:
    • 1.5% for first 10 years - 1% thereafter
    • May charge for switchin to other providers
    • Min cont £20 per month
    • Permit payment breaks or changes to payments
    • Run by trustees or an authorised stakeholer manager
• SIPPS
  • PP plan - investors can select their own investment portfolio while benefiting from same tax relief
  • Possible to borrow up to 50% of assets
  • Take 25% tax free lump sum at retirement
  • Set up as trusts and have trustee to oversea
  • Also offers income draw down facility
• AVC's
  • method to top up OPS
  • generally subject to lower charges than if member began investing into seperate scheme
  • flexibility to stop or vary payments
  • Tax relief on conts up to certain limits

DC schemes take a long term investment view

·         Aim to make gains over a number of years thus smoothing out periods of short term volatility.

·         The earlier contributions are started, the less usually needed to paid in later years to meet an investment goal.

Lifestyling is a method by which schemes offer asset allocations which change in line with the number of years that a member has until retirement.

·         Most contributions invested in equities initially

·         As member nears retirement, exposure to equities is reduced in favour of bonds and cash, which offer safer and more predictable returns

·         Designed to give members the opportunity for long term growth and then preserve pot of money in later years.

·         Can prove problematic in unexpected circumstances such as early retirement.

·         Schemes usually provide forecasts

·         DC schemes allow investors to select their own investment from a range of funds

·         Also have a default option designed to be suitable for the widest range of members.

o   Commonly include UK or global index trackers

o   Balanced managed fund

o   Equity exposure of 80%

o   Stakeholders have a legal requirement that the default fund be a Lifestyle option

·         80% of assets in DC funds are in a default fund

o   May not provide the best investment for every investor.

Government grants tax relief on all pension contributions to encourage wide participation

·         Company scheme – employer deducts contributions from pay before tax but after NI.

·         Personal pensions – Provider claims back the basic rate, and higher rate taxpayers need to claim the difference back themselves

DC schemes must pay some tax on dividends from equities, but is not subject to capital gains tax

·         Pension income subject to income tax

·         Some schemes may allow members to withdraw money from their scheme before retirement, which would be an unauthorised payment subject to a charge.