Liability Driven Investment:Unique insights for UK pension schemes

Annual Survey 2018

2 | XPS Investment

LDI Report | 1

IntroductionWelcome to the first XPS LDI survey

It is these ebbs and flows that LDI is specifically aimed at addressing. Whilst no-one knows the direction of markets, what we do know for sure is that LDI will smooth out those weekly lumps and bumps, freeing up pension scheme investors to focus on the difficult bit – earning a return. Whilst the detail of LDI is complicated, when done correctly it is highly effective and should not absorb unnecessary governance time.

Pension schemes get this. That is why approximately 49% of UK liabilities are hedged using LDI and why 2,140 mandates are in place, growth of 17% over the year. It is great to see that growth initially driven by medium and large schemes is now flowing very firmly to smaller schemes. This growth has been supported by well designed funds and directive consulting, combined with the increasing use of LDI through platforms and fiduciary managers providing a means for schemes of any size to do the hedging that they need. Platforms and fiduciary managers

accounted for 41% of new mandates. The development of typical scheme profile funds have enabled schemes to construct pragmatic solutions, safe in the knowledge that the simplicity of the tools also means there is less to get wrong. In total 66% of pooled LDI investments are in ‘profile funds’ rather than bucket fund building blocks.

It does raise a question, when does this all stop? Timing this could be lucrative. Perhaps when the average scheme has passed the peak of its cashflows we’ll then see a rising of yields and a decrease in the demand for gilts? The long lost buying opportunity wanted by so many for so long, ripe for the taking? Not so fast - by definition the real buying opportunity will only arise when the necessity falls away. Like those tantalisingly cheap last minute holidays, of spectacular irrelevance for a tired family needing to secure a guaranteed break in peak season. By definition not everyone can bag the bargain holiday. Uncertainty is the real cost of waiting. LDI is no different.

2017 was a year when LDI delivered what it said on the tin. Unlike the storming performance of 2014 or 2016 driven by sizeable yield falls, broadly speaking, gilt yields ended up where they started. For a scheme looking at their funding level once a year you’d be forgiven for assuming nothing happened in between. However, the reality is that yields fluctuated by 0.10% to 0.15% on a weekly basis, introducing a weekly move of around 1-3% on the liability value for a typical scheme.

Waiting for a gilt buying opportunity is like holding out for a bargain last minute holiday. Fine if you can afford to take the risk, but a very risky game. By definition not everyone can bag a bargain holiday. LDI is no different.

Simeon WillisChief Investment Officer

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The LDI market as it stands today

Total mandates

1,828 2,140mandates

There were 312 new LDI mandates implemented in 2017. Only 28 of these were segregated and bespoke pooled mandates, showing the popularity of lower governance approaches.

Proportion of liabilities hedged

49% of liabilities hedged using LDI

We estimate the UK private sector had a total DB pension scheme liability of around £1.97trn1 on a low-dependency gilts + 0.5% basis as at December 2017. Whilst there are still some vocal dissenters, there is general agreement amongst the professional investor community that schemes should be hedging the majority of interest rate and inflation risk. With this in mind there is still scope for further hedging growth.

Size of new mandates

£195mhedged in each new mandate on average

The average value of liabilities hedged across new mandates in 2017 was £195m. This compares to an average of £495m per mandate at the start of the year.

Use of ‘profile funds’

66% of pooled LDI investors are using profile funds

Smaller schemes are continuing to take advantage of the improved accessibility and affordability of today’s solutions. The majority of pooled investors are using ‘profile funds’ - pooled funds which represent a typical scheme’s cashflows.

1 Estimated as at 31 December 2017 based on data from the PPF Purple Book (2017) and discount rates of gilts + 0.5% pa. We note 49% is likely to underestimate the actual level of hedging as it excludes hedging achieved through holding bond assets outside of a specific LDI hedging program.

All market totals assume that LGIM’s LDI business remains as it was at 31 December 2016 sourced from the KPMG LDI survey 2017

Notional amount of liabilities hedged

£904bn £965bnliabilities hedged

Over 2017 the total notional value of liabilities hedged by LDI strategies has continued to increase, moving from £904bn to £965bn – an increase of 7%. Given the minimal movement in yields between year ends broadly all of this gain can be attributed to new LDI mandates.

LDI Report | 3

The fund manager landscape

The operation of the LDI market has become more interwoven as fiduciary managers and platforms offer clients access to fund managers through their own pooled products which are managed by an underlying fund manager. As at 31 December 2017 there were 463 clients accessing LDI via a fiduciary or platform,

which accounted for 160 mandates at underlying managers. We have adjusted the total mandates to account for this.

LGIM declined to participate in this year’s survey. Therefore all LGIM data is sourced from the KPMG LDI Survey 2017 and assumed to remain constant as at 31 December 2017.

In Legal and General plc’s year end results published in March 2018 it states that their Solutions business assets (which includes LDI) grew by 12% over 2017, as such our assumption of remaining static is likely to be a conservative estimate.

Total hedged liabilities up from £904bn to £965bn

Total LDI mandates up from 1,828 to 2,140

Most LDI providers continued to add to their tally over the year with pooled LDI the main force of growth.

2017 was a big year for BMO, taking on

140 new mandates – nearly half of all new mandates!

Rachel Titchen Consultant

LGIM

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*LGIM data as at 31 December 2016 source: KPMG LDI Survey 2017

4 | XPS Investment

Segregated and bespoke pooled solutions

Segregated and bespoke pooled solutions now make up 89% of the overall LDI market with an average mandate size of £1.3bn.

Notional amount of liabilities hedged in segregated and bespoke pooled mandates

Number of segregated and bespoke pooled mandates

A segregated or bespoke pooled LDI mandate is tailored to a scheme’s specific requirements. These solutions can provide a more accurate hedge – arguably more important when looking at higher hedging levels – and can also offer the potential for higher leverage levels. Bespoke pooled solutions in particular look to achieve the benefits of a segregated arrangement but without the additional paperwork. The benefits and drawbacks of either will be specific to the requirements and circumstances of the scheme.

Dominated by big ticket mandates this market represents 89% of the overall LDI market with an average size of £1.3bn.

However, we expect to see the focus of growth to continue to shift towards pooled mandates as smaller schemes continue to pour into the market.  

*LGIM data as at 31 December 2016 source: KPMG LDI Survey 2017

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LDI Report | 5

Pooled solutions

Pooled LDI represents 11% of the overall LDI market but accounts for a whopping 87% of this year’s new mandates as more small and medium sized schemes begin to hedge.

Pooled funds in the limelight: accounting for

87% of new mandates

Mark MinnisHead of LDI

Notional amount of liabilities hedged in pooled mandates

Number of pooled mandates

*LGIM data as at 31 December 2016 source: KPMG LDI Survey 2017

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6 | XPS Investment

Everyone is invited to the LDI party

The marketplace continues to innovate and adapt to make LDI more accessible for all schemes. We highlight several emerging trends below:

Platforms (Mobius Life)

73 143 Growth in mandates accessed through the Mobius Life Platform over 2017

A platform provides a means for pension schemes to access a wide range of investment funds, whilst having the administrative simplicity of dealing with one manager. Our analysis focusses on Mobius Life as they dominate the non-fiduciary DB platform market. 22% of new LDI mandates over 2017 were via the Mobius Life platform.

There are a number of other platforms available, often associated with fiduciary management and DC investment. We cover fiduciary management separately below.

Fiduciary management

263 320 Growth in mandates accessed through fiduciary management over 2017

Fiduciary managers have been strong advocates for the merits of hedging. Therefore it is not surprising that the fiduciary management market grew at a steady pace, adding a further 57 mandates accounting for 18% of new LDI mandates over 2017.

You’d be forgiven for thinking that LDI can get a bit complicated. But the means of accessing LDI has broadened considerably in recent years making it easier to implement than ever.

Tim MillerConsultant

LDI Report | 7

The earliest pooled funds followed the ‘bucketed’ approach – a range of ‘building blocks’ allowing pension schemes to replicate the timing of their cashflows by combining funds with different maturities.

With innovation and the desire for simplicity came the standard scheme ‘profile’ approach. These are a simpler range of pooled funds which aim to match the liability profile of a typical scheme, often with variants catering for non-pensioners and pensioners.

The increasing demand for profile funds has seen some providers introduce new profile fund ranges and others removing their bucketed fund ranges altogether. Profile funds now account for two thirds of pooled LDI investments.

It will be interesting to see how this trend develops in future.

Scheme profile vs bucket LDI funds 2016 to 2017

61%

66%

39%

34%

Profile

Bucket

We see an increasing number of schemes using the pragmatic scheme profile funds as a relatively lower governance way of increasing their hedging levels.

Nick Harvey Principal

2016

2017

8 | XPS Investment

Our thanksWe would like to thank the following organisations for their involvement in this year’s survey:

Aberdeen Standard, Aon, Aviva, AXA IM, BlackRock, BMO, Cardano, Goldman Sachs, Insight, Mercer, Mobius Life, PIMCO, River & Mercantile, Russell Investments, Schroders, SEI, State Street and Willis Towers Watson.

AuthorsSimeon WillisChief Investment OfficerE: simeon.willis@xpsgroup.comT: 020 3327 5000

Nick HarveyPrincipalE: nick.harvey@xpsgroup.co.ukT: 020 3327 5000

Tim MillerConsultantE: tim.miller@xpsgroup.co.ukT: 020 3327 5000

Mark MinnisHead of LDIE: mark.minnis@xpsgroup.comT: 0113 224 0200

Rachel TitchenConsultantE: rachel.titchen@xpsgroup.co.ukT: 0121 230 1900

LDI Report | 9

xpsgroup.com

About usXPS Pensions Group is the largest pure pensions consultancy in the UK, specialising in pensions actuarial, investment consulting and administration, with revenues of over £110 million. We are the only UK pensions specialist listed on the FTSE. With over 900 staff in 15 UK locations, our business combines expertise, insight and technology to address the needs of both pension trustees and sponsoring companies for over 1,200 pension schemes and undertakes pensions administration for over 600,000 scheme members.

XPS Investment provides clear and independent investment advice that can be quickly and effectively implemented. We advise pension schemes and their corporate sponsors and have over £20bn of assets under advice.

Important information: Please note the opinions expressed herein do not take into account the circumstances of individual pension funds and accordingly may not be suitable for your fund. The information expressed is provided in good faith and has been prepared using sources considered to be reasonable and appropriate. While information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This document may also include our views and expectations, which cannot be taken as fact. The value of investments and the income from them can go down as well as up as a result of market and currency fluctuations and investors may not get back the amount invested. Past performance is not necessarily a guide to future returns. The views set out in this document are intentionally broad market views and are not intended to constitute investment advice as they do not take into account any client’s particular circumstances.

Please note that all material produced by XPS Investments is directed at, and intended solely for the consideration of, professional clients within the meaning of the Financial Services and Markets Act 2000 (FSMA). Retail or other clients must not place any reliance upon the contents. This document should not be distributed to any third parties and is not intended to, and must not, be relied upon by them. Unauthorised copying of this document is prohibited.

This document should not be distributed to any third parties and is not intended to, and must not be, relied upon by them. Unauthorised copying of this document is prohibited.

© XPS Investment 2018. XPS Investment is the trading name of Xafinity Consulting Ltd and Punter Southall Investment Consulting Ltd. Registration: Xafinity Consulting Ltd, Registered No. 2459442. Registered office: Phoenix House, 1 Station Hill, Reading RG1 1NB. Punter Southall Investment Consulting Ltd Registered No. 6242672. Registered office: 11 Strand, London WC2N 5HR. Both companies registered in England and Wales. Punter Southall Investment Consulting Ltd (FCA Register number 528774) and Xafinity Consulting Ltd (FCA Register number 194270) are both authorised and regulated by the Financial Conduct Authority (FCA) for investment business.

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