XPS Investment NewsBringing you the latest investment news, insights and opinion from across the pensions industry

Equity markets – all the bad news priced in?Equities fell notably in both October and December leading to the worst quarter since Q3 2011.

January2019

Poppy Street Investment Consultant

In brief- Worst quarter for equity

markets since 2011

- Listed property pricing is significant in challenges on the high street

- Brexit uncertainty prompting fall in gilt yields, raising liabilities

Key considerations for trustees- CMA published its final report

on the investment consulting and fiduciary management market in December 2018. Make sure you know what actions your scheme needs to take

- Are you making the most of illiquidity within your investment strategy? In this note we look at your options to get more out of your investments

Click to watch Poppy’s Market Overview

The falls stemmed from a range of global issues, not least ongoing concerns around international trade between US and emerging market countries, in particular China, and the rising US interest rate environment putting pressure on sources of economic growth.

The surprise is not so much that the falls have occurred, but rather that they didn’t occur earlier. These underlying issues are not new. Many of the pressing international trade disputes centre around protectionist stances introduced in a quest for ‘fairness’, despite the generally recognised side effects of these types of policy. The longer term challenge this presents for global trade could therefore be marked.

That said, an investment in global equities made in March 2018 would still be slightly up. So the falls in the fourth quarter only took back two prior quarters of returns.

Listed UK property experienced very substantial falls, reflecting investor concern in particular around the retail sector. Time will tell the extent to which this pessimism is reflected in surveyed prices that affect the price that property funds trade at, which are reported with a lag.

High yield bonds suffered a more modest fall resulting from widening credit spreads with investment grade corporate bonds close to flat over the quarter.

Despite some sensationalist press headlines during December in relation to what were actually fairly modest fluctuations, the Sterling exchange rate to the Euro and the Dollar ended the quarter much where it started.

Over quarter four a typical pension scheme will have suffered a fall in funding level of 4.7%. This is the result of falls in asset values and a rise in liabilities.

Published UK inflation statistics have been coming down over the year but longer term inflation expectations have been more stable, buoyed by potential inflationary pressures such as Brexit related currency depreciation.

In December the Monetary Policy Committee voted unanimously to keep base rates at 0.75% citing the uncertainties around Brexit and a slowing global economy. The scope for the UK’s exit deal to affect future base rates, in either direction, was noted by the MPC. The perceived low probability of Theresa May’s withdrawal agreement being accepted by Parliament and the potential to find ourselves back to square one contributed to gilt yields falling modestly over the quarter, mostly in December, pushing liabilities up.

Source: Radar Source: Radar

Liabilities up +4.2%

Assets down -2.1%

Funding level down -4.7%

1 month to 31 December 2018 3 months to 31 December 2018

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

-6.8%-3.7%

-3.5%

-2.4%

-1.8%

1.1%

2.2%

2.5%

-8% -6% -4% -2% 0% 2% 4%

Global equitiesUK equities

UK property (listed)

Emerging market equities

High yield bonds

UK corporate bonds

Fixed interest gilts

Index linked gilts

-10.5%

-10.2%-9.3%

-3.9%-3.3%

-0.2%1.9%1.9%

-12% -10% -8% -6% -4% -2% 0% 2% 4%

Global equities

UK equitiesUK property (listed)

Emerging market equitiesHigh yield bonds

UK corporate bondsFixed interest gilts

Index linked gilts

Asset class Favourable Neutral Unfavourable

Developed equities

Emerging market equities

Investment grade corporate bonds (UK)

High yield bonds (global)

Property

Private markets

Equity option strategies

Pensioner buy-in

XPS Investment Asset Class Views

XPS Investment

The CMA’s final report and what it means for your scheme

For more details of the remedies and background, please see our December 2018 CMA News alert

Following a market study undertaken by the Financial Conduct Authority concluding in September 2017, the Competition and Markets Authority (CMA) was commissioned to investigate the extent that competition was working within the investment consulting (IC) and fiduciary management (FM) markets and address any short comings identified. The CMA published its final report on 12 December 2018.

The CMA found that there were adverse effects on competition in both markets and have set out a package of 8 remedies alongside 4 supporting remedies. In this note we have focused on Remedy 1 and Remedy 7 as these may require action by trustees. All other remedies will be implemented by the consultants, fiduciaries or other market participants.

Remedy 1: Mandatory competitive tendering for FM

Action: Trustees using Fiduciary ManagementWhen appointing FM for the first time for more than 20% of the funds’ assets, trustees are required to run a competitive tender process. This can be a closed process but must include 3 FMs. There is no requirement to obtain independent oversight but the Pensions Regulator (TPR) is going to provide guidance (Remedy 3).

If trustees have not met these requirements with the appointments made to date, they will be required to do so within 5 years of the FM appointment or within 2 years of the CMA Order which is expected in early 2019, whichever is longer. FMs will be prohibited from accepting appointments that have not gone through a competitive tender process.

XPS viewThis has scope to introduce much needed competitive tension into the FM market. The CMA has linked formal tenders with a 20% reduction in FM fees. We believe the voluntary use of a third party evaluator will enhance the benefit.

Remedy 2: Separation of advice and marketing by IC/FMs

Remedy 3: TPR to provide guidance on competitive tendering process

Remedy 4: Requirement on FMs to report itemised fees to existing customers (FM)

Remedy 5: FMs to disclose itemised fees to prospective customers

Remedy 6: FMs to report their past performance by reference to a common methodology and template

Remedy 7: Duty on trustees to set strategy objectives for their investment consultant

Action: Trustees using Investment ConsultantsTrustees will be able to better monitor the performance of their investment consultants by setting and measuring them against an appropriate set of strategic objectives, which are closely linked to the scheme’s investment objectives where possible. The timeframe for setting objectives will be 6 months after the CMA Order which is expected in early 2019.

XPS viewSetting measurable goals in advance has clear benefits. Measuring the performance of a consultant needs to encapsulate a range of aspects, and we believe the CMA has provided sufficient flexibility for schemes to set objectives for their consultant to reflect the nature of the relationship.

Remedy 8: Requirement on ICs and FMs to report performance of recommended asset management ‘products’ or ‘funds’ using a basic minimum standard

Making the most of illiquidityGiven the long term investment horizon of defined benefit pension schemes, illiquid assets can play an important role. However, we find that the majority of pension schemes are often missing out on the benefits that illiquid assets can offer, due to excessive caution over ‘locking up capital’ for an extended period of time.

In this note, we discuss the role of illiquid assets and show how a scheme can confidently identify how much of a role they should play in your portfolio, resulting in improved returns for less risk.

Sarita Gosrani Investment Consultant

What are illiquid assets?

Liquidity refers to the ease with which the investor is able to buy and sell the asset. The speed at which the asset can be sold at fair value places a natural constraint on the investors that can own the asset, and therefore affects the price and return that can be earned.

Pension schemes have a comparative advantage of relative certainty over longer term cash requirements, limited regulatory constraints (unlike say banks or insurers) and a long time horizon.

There are a wide spectrum of asset liquidities, ranging from daily traded, through to weekly, monthly, quarterly, yearly or even tens of years. An understanding of the range of options and how this can align with a scheme’s requirements presents opportunity for pension schemes to tailor to their individual needs, and in doing so increase return, reduce risk, or a combination of the two.

The table below sets out a range of example asset types and their typical liquidity:

Asset class Typical liquidityGilts Daily

Equities Daily

Investment grade corporate bonds Daily

Diversified growth funds Daily to weekly

Multi sector credit Daily to 6 monthly

Property 6 months to 1 year

Senior private debt 5-7 years

Infrastructure debt Up to 25 years

Historically it was larger pension schemes that have been able to gain exposure to illiquid assets through direct investing or bespoke mandates. However this is no longer an exclusive club and the use of pooled funds mean that small and medium sized schemes can also benefit without incurring excessive cost or governance.

The role of illiquid assets

In general most pension schemes can benefit from an allocation to illiquid assets. Some of these benefits include:

– Enhanced returns: Additional returns can be gained simply from tolerating

illiquidity with no increase in risk;

– Diversification: Scope to invest in a wider array of assets increases the ability to gain exposure to new and genuinely diversifying markets thereby improving diversification in the portfolio;

– Inflation protection: Some illiquid assets such as real estate or infrastructure can provide an inflation linked stream of income;

– Income generation: Despite being illiquid, a surprising number of illiquid investments pay off predictable cashflows through time that create greater certainty of outcome whilst also contributing towards the practical issue of paying pensions.

Current expected return: Gilts + 2.1% pa

1 in 20 year scenario risk: -£18m

Current expected return: Gilts + 2.2% pa

1 in 20 year scenario risk: -£13m

Expected return enhanced and risk reduced

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

80,000,000

90,000,000

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

80,000,000

90,000,000

Daily

Wee

kly

Month

ly

Quarte

rly

Sem

i-ann

ual

Annua

l

5 yea

rs

10 ye

ars

Current – Liquidity ladder

Liabilities Collateral Assets 1 in 20 downside shock

Liabilities Collateral Assets 1 in 20 downside shock

Daily

Wee

kly

Month

ly

Quarte

rly

Sem

i-ann

ual

Annua

l

5 yea

rs

10 ye

ars

Alternative – Liquidity ladder

Global equities25%

Diversified growth fund

25%

Investment grade credit

20%

LDI30%

Current

Global equities10%

Diversified growth fund

20%

Long lease property

10%Multi sector

credit15%

Private Debt15%

LDI30%

Alternative

Substantial liquidity headroom

Su�cient headroom maintained at all points

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

80,000,000

90,000,000

0

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

80,000,000

90,000,000

Daily

Wee

kly

Month

ly

Quarte

rly

Sem

i-ann

ual

Annua

l

5 yea

rs

10 ye

ars

Current – Liquidity ladder

Liabilities Collateral Assets 1 in 20 downside shock

Liabilities Collateral Assets 1 in 20 downside shock

Daily

Wee

kly

Month

ly

Quarte

rly

Sem

i-ann

ual

Annua

l

5 yea

rs

10 ye

ars

Alternative – Liquidity ladder

Global equities25%

Diversified growth fund

25%

Investment grade credit

20%

LDI30%

Current

Global equities10%

Diversified growth fund

20%

Long lease property

10%Multi sector

credit15%

Private Debt15%

LDI30%

Alternative

Substantial liquidity headroom

Su�cient headroom maintained at all points

The chart below shows an enhanced allocation incorporating multi sector credit (monthly traded), long lease property (6-12 months) and private debt (5-7 years).

The enhanced portfolio improves the risk/reward balance of the portfolio whilst still allowing for a sufficient liquidity margin between assets held and benefit payments.

The long term time horizon that pension schemes enjoy does not detract from the fundamental importance of a scheme having sufficient liquidity at all times to meet its obligations.

Therefore, the only way of confidently allocating assets to illiquid investments is to have very clear information on your liquidity requirements.

We have developed an in house liquidity model that maps the liquidity of a scheme’s assets compared to the liquidity required to pay the scheme’s liabilities. We also test that there remains sufficient “liquidity headroom” even in the event of a market shock.

The chart below shows the liquidity profile of an example scheme with a fairly typical allocation to equities, diversified growth funds, bonds and Liability Driven Investment.

– The solid pink line represents the combined value of assets that can be sold for cash at fair value, if required, within a given time period. For example daily traded assets account for £60m of this fund. Weekly traded assets account for a further £20m meaning that a total of £80m can be sold for cash within a week. Note, this chart should not be confused with a cashflow projection, for example a gilt will have long dated cashflows but can still be sold very quickly because there is a liquid market.

– The shading represents the scheme’s liquidity requirements. The blue area shows the cumulative cashflow required to pay benefits (which is relatively small but builds up) whilst the dark grey area represents the collateral required to hedge the interest rate and inflation risk inherent in the liabilities.

In the example there is plenty of “liquidity headroom” because the pink line is above the blue shading at all points.

Furthermore, even after applying a 1-in-20 risk event (the pink dotted line) there is still a large liquidity margin between the assets held and the liquidity requirements, providing ample scope to incorporate some illiquidity.

Your scheme’s liquidity profile

xpsgroup.com

Important information: Please note the information and opinions expressed herein do not take into account the circumstances of individual pension funds and accordingly may not be representative of the circumstances affecting your fund. This note, and the work undertaken to produce it, is compliant with TAS 100, set by the Financial Reporting Council. No other TASs apply. The note has been written on the basis that decisions will not be based on its contents. Appropriate advice should be obtained before any decisions are made. 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 2019. 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.

Part of XPS Pensions Group

To discuss any of the issues covered in this edition, please get in touch with Poppy Street or Simeon Willis:

Simeon WillisChief Investment Officer

t te e

020 3327 5617 0118 313 0700

poppy.street@xpsgroup.co.uk simeon.willis@xpsgroup.com

Alternatively, please speak to your usual XPS Pensions contact.

Poppy StreetInvestment Consultant

Factoring in your direction of travel

Liquidity is not just a matter of looking at the portfolio today but also assessing how well it is placed to evolve as time and the funding level progress.

Therefore other important considerations include the scheme’s cashflow profile and the scheme’s journey plan i.e. if you are on a de-risking path. For example illiquid investments such as private equity funds might be inconsistent with a de-risking plan as the scheme would not be able to reduce the holding in favour of lower risk assets within the desired timeframe.

However the range of illiquid assets accessible to pension schemes now provide plenty of low risk options that can play a role both today and in the future as part of a scheme’s de-risking journey.

Conclusion

The opportunities for small and medium sized pension schemes to benefit from investing in illiquid assets has improved significantly in recent years.

We believe schemes can harness this, and using robust analysis of the scheme’s requirements against which alternative strategies can be assessed, they can identify and implement a portfolio that is markedly improved.

The ability to invest in illiquid assets is a distinct advantage for pension schemes, and one that can be used to enhance returns and reduce risk.Sarita Gosrani