Liability Aware Investing Integrated Liability Plus Solutions Fund Guide - 2019
Contact Pensions Solutions Team Standard Life Investments 1 George Street Edinburgh EH2 2LL Email: pensions_solutions@standardlife.com
Standard Life Investments Liability Aware Investing using Integrated Liability Plus Solutions (ILPS) A pooled fund solution providing both growth and liability hedging components Fund Guide The Integrated Liability Plus Solutions ( ILPS ) fund range is provided by Standard Life Investments for the exclusive use of UK Defined Benefit ( DB ) pension schemes. The funds are sub-funds of Standard Life Investments Liability Solutions ICAV, an open-ended umbrella fund incorporated as an Irish Collective Asset-management Vehicle authorised by the Central Bank of Ireland. They are Qualified Investor Alternative Investment Funds ( QIAIFs ) and are therefore subject to the Alternative Investment Fund Managers Directive and relevant Irish regulations. Overview The ILPS fund range has been designed to allow UK DB pension schemes to access growth assets alongside interest rate and inflation hedging (also known as liability hedging ) in a single pooled investment solution. The funds are intended to meet dual pension scheme objectives to: Provide protection (i.e. hedge) against changes in the value of liabilities arising from movements in interest rates and inflation expectations. At the same time, seek a return in excess of cash on the amount invested in the funds. This may be advantageous to pension schemes as it allows the capital invested in their liability hedging strategy to continue to target returns in excess of the liabilities. Pension scheme risk management Investing in the ILPS funds is designed to mitigate the risk of adverse movements in the pension scheme s funding level (i.e. the ratio of the value of assets to liabilities). Such movements can arise from two main sources: Changes in the liabilities Changes in interest rate and inflation expectations affect the value of the pension scheme s liabilities. The use of liability hedging can reduce exposure to such changes as the liability hedging instruments are expected to respond to these changes in a similar way to the liabilities. There are risks other than interest rate and inflation that affect the liabilities, for example mortality expectations. These risks are not addressed through the ILPS funds. Assets underperforming the liabilities This can be thought of in two ways: Firstly, the risk that arises from adverse market conditions leading to poor asset returns. The growth funds used within the ILPS fund range aim to mitigate this risk through exposure to a diverse range of market positions, seeking to deliver positive (absolute) returns in a wide range of economic scenarios. Secondly, if a large proportion of a pension scheme s assets have to be tied up in low returning assets (i.e. cash) to implement liability hedging, this could lead to a detrimental impact on overall portfolio returns. Using the ILPS funds allows the assets committed to a liability hedging solution to also seek to generate a return in excess of the change in value of pension liabilities. There are two types of funds in the ILPS fund range; one providing interest rate only protection ( Nominal Fund ) and the other providing real rate protection, i.e. containing both interest rate and inflation hedging ( Real Fund ). For pension schemes with both fixed and inflation-linked liability cashflows, they may wish to invest in a combination of the Nominal Funds and the Real Funds. The Nominal Funds and the Real Funds invest directly in liability hedging instruments as well as holding shares in a pooled sub-fund aiming to generate growth. This allows the ILPS funds to deliver both of the characteristics described above.
What is inside the ILPS funds? Each of the ILPS funds invests in: A Growth fund this allows the ILPS fund to target an overall return in excess of cash (ignoring any contribution from the hedge portfolio). A Hedge portfolio this is the portfolio of interest rate (Nominal funds) or interest rate and inflation (Real funds) instruments used to provide liability hedging. Cash this is used for the prudent risk management of the funds, described below. Growth funds These funds are also sub-funds of Standard Life Investments Liability Solutions ICAV but are not available to external investors as stand-alone funds. These are for the use of the ILPS funds only. The funds currently available are as follows: Liability Aware Absolute Return III Fund (the LA AR III Fund ) This is a growth fund which seeks to facilitate a return of cash (6 month LIBOR) +5% p.a. (gross of fees) over rolling three year periods (net of the impact of the liability hedge) in the relevant ILPS funds. The fund exploits market opportunities through active allocation to a diverse range of market positions. The fund uses a combination of traditional assets and investment strategies based on advanced derivative techniques, resulting in a diversified portfolio. Liability Aware Absolute Return II Fund (the LA AR II Fund ) This is a growth fund which seeks to facilitate a return of cash (3 month LIBOR) +3% p.a. (gross of fees) over rolling three year periods (net of the impact of the liability hedge) in the relevant ILPS funds. The fund looks to exploit market opportunities primarily in the bond, currency and money markets, through active allocation to a diverse range of market positions. The fund uses a combination of traditional assets and investment strategies based on advanced derivative techniques, resulting in a diversified portfolio. Hedge portfolios The Hedge portfolios will invest in a range of instruments that provide similar interest rate and inflation sensitivities to the appropriate Target Liability Profile (defined below). Target Liability Profile (Nominal and Real) The Target Liability Profiles are a set of cashflows (either fixed or inflation-linked) as defined by Standard Life Investments. The cashflows are intended to be representative of an average UK pension scheme s 1 liability cashflows. At the outset, the profiles were intended to provide c. 20 years of duration 2 (Nominal profile) and c. 23 years of duration (Real profile) [before the impact of leverage see below]. These cashflow profiles will roll down (mature) over time as the cashflows become payable. This means that, all else being equal, the duration of the ILPS funds will tend to decrease over time. Standard Life Investments may launch additional profile funds within the ILPS fund range to meet the needs of different pension scheme investors. Hedging instruments In order to implement the Hedge portfolio, the fund manager will choose from a range of suitable hedging instruments, depending on the fund manager s long-term assessment of relative efficiency of such instruments. Suitable hedging instruments currently include swaps and unfunded 3 gilts. Cash As well as the performance objectives of the ILPS funds, there is an objective to maintain capital adequacy in the funds. This means cash management within the ILPS funds plays a vital part in ensuring the investment objectives are met. Cash in the ILPS funds (including the Growth funds) is invested in a money market mandate managed by Standard Life Investments. This is managed in line with liquidity requirements set out by the ILPS fund manager. These funds follow similar investment processes to other Aberdeen Standard Investments absolute return strategies funds but may use different implementation techniques. This may lead to different performance outcomes. 1 Using data from The Pensions Regulator and Standard Life Investments. 2 Duration is a measure of sensitivity to changes in interest rates and/or inflation. It is calculated as the average time to payment (weighted by the present value of each cashflow), measured in years. 3 Unfunded instruments provide exposure to the price movements of underlying reference assets but do not require capital to be invested up front. Derivatives are a type of unfunded instrument.
Investment implications of using leveraged liability hedging The ILPS funds (and the Growth funds) use derivatives and other unfunded instruments to meet their investment objectives. The use of these instruments introduces leverage. Leveraged exposure to movements in interest rates and inflation can be advantageous as it allows the leveraged fund to offer liability hedging on a larger amount of a pension scheme s liabilities than the amount invested (for example, hedging 2 of liabilities for every 1 invested). However, it should be noted that leverage magnifies the impact of changes in interest rates and inflation compared with an unleveraged fund. For example, an ILPS fund with 2x liability leverage and duration of 20 years would be expected to change in value (either positive or negative) by around 10% for a 0.25% p.a. change in interest rates, whereas a similar unleveraged fund might change in value by around 5%. Leverage therefore provides flexibility but it also introduces the risk that cash held within the ILPS funds could be depleted more quickly than in a similar unleveraged fund. This situation is most likely to happen if long-term interest rates rise (and/or inflation expectations fall) quickly and unexpectedly. The Hedge portfolio will fall in value as collateral is posted out to counterparties. Unless addressed, this could lead to the affected ILPS fund running out of collateral 4. We describe the risk management processes of the ILPS funds below. Risk management Risk management processes are operated on a daily basis for each ILPS fund. These seek to maintain adequate, but not excessive, cash to support the leverage in the ILPS funds. Quantitative risk measures are used to monitor that each ILPS fund holds sufficient cash to withstand a severe market movement. These types of market movements would not be expected to be a regular occurrence; however it is necessary to have processes in place to protect both the ILPS funds and the investor in these situations. ILPS fund management considerations Rebalancing limits At outset, each ILPS fund will have leverage of 2x on the hedging exposures. Leverage will, however, vary over time, partly due to the roll down (maturing) of the Target Liability Profiles and partly due to changing market conditions. In the normal course of events, the Hedge portfolios will be maintained within a 1 year duration tolerance relative to the Target Liability Profiles. As explained above, each ILPS fund aims to hold adequate but not excessive amounts of cash at all times. If the amount of cash is considered to be too low, the fund manager will implement a Recapitalisation Event to move the ILPS fund to a less leveraged position. Similarly, the manager will implement a Releveraging Event (i.e. leverage will be increased) if the cash levels are considered excessive. A Releveraging Event could happen when interest rates are falling (and the Hedge portfolio is increasing) or when growth assets perform very strongly. Standard Life Investments has discretion on when to trigger this type of activity. Fund manager discretion The amounts of additional (or excess) cash requested (or distributed) during Recapitalisation (and Releveraging) Events will be determined by Standard Life Investments. The size of the amounts will be intended to provide a prudent level of cash following the Event. 4 In this situation it is important to remember the overall context. The value of an ILPS investor s liabilities is also likely to be falling at this point and their overall funding level improving. They are therefore likely to be considering adjustments to their overall portfolio at this time, including the level of hedging required.
ILPS investor considerations Recapitalisation Event If a Recapitalisation Event is instigated, investors in the affected fund must transfer the required amount of cash within 7 days of the Notice to retain their existing amount of liability hedging. After the Recapitalisation Event, each of the shares held by the investor will be providing less liability hedging than before the Recapitalisation Event. If cash is received within this window, the investor s target liability hedging coverage is unchanged. If the investor is unable to provide the required cash in the specified window, then there will be a reduction in their overall target level of liability hedging provided by the ILPS fund. In addition, a small proportion of their shares will be sold to cover the cost of this hedging adjustment. If the investor does not provide the cash top-up during the window, but subsequently wants to increase their liability hedging, they can submit a subscription for the additional amount at any of the following normal dealing dates. This will be used to purchase additional shares in the relevant ILPS fund (incurring any relevant dilution adjustment 5 ) which will increase the investor s level of liability hedging. During the time between the Event and the subscription, the investor s liability hedging will be lower than the pre-event level. Depending on market movements over the period, it may not be increased to the same pre-event level. Releveraging Event In this situation, shares in the ILPS fund will be redeemed for cash 7 days after the Notice is issued. An investor can choose to invest the cash elsewhere or to re-invest in the ILPS fund to increase their liability hedging. Contingency Assets An Investor can specify additional assets held through Standard Life Investments to be used as a contingency asset portfolio. These assets will be the first port of call in a Rebalancing Event.In a Recapitalisation Event, Standard Life Investments have the authority to use the value of these assets to top up the ILPS fund and maintain the investor s level of liability hedging. Assuming the total contingency asset portfolio is sufficient to meet the requirements of a Recapitalisation Event, the investor s target liability hedging will be maintained throughout. The investor can select up to three suitable funds 6 to act as their contingency asset portfolio, along with a priority order. These will be used to top-up the ILPS fund in the order of priority selected. If the value of the contingency asset portfolio is not sufficient 7 to cover the amount required, an additional cash request will be sent to the investor. If market conditions continue to deteriorate during the particular Event window, the fund manager has the right to unilaterally reduce the Hedge portfolio and Growth fund positions in the affected ILPS fund. This would mean the liability hedging coverage and/or the Growth fund allocation is reduced beyond the usual tolerances and the performance objectives for the Hedge portfolio (and for the affected ILPS fund) may be impacted. This will apply to the ILPS fund in totality and is irrespective of individual client situations. The liability hedging coverage and Growth fund allocation will be restored to within normal tolerances as soon as practicable following the Event. For a Releveraging Event, the cash redemption will simply be sent to the first of the specified contingency asset portfolio funds. No pro-rata or discretionary management of the contingency asset portfolio is offered on the part of Standard Life Investments, unless investors already have separate arrangements in place. The contingency asset portfolio can be topped up at any point by investors. 5 A dilution adjustment aims to ensure that the investors buying or selling shares in the fund bear their own share of dealing costs and that these costs are not borne by other investors. 6 From a list of permissible funds from the Standard Life Investments TIP fund range. Funds must meet minimum liquidity criteria to be permissible, as determined by Standard Life Investments. 7 As determined by Standard Life Investments.
Things to consider when investing in the ILPS funds Each pension scheme investing in the ILPS fund range will have specific requirements. We would expect the majority of pension schemes to invest in a combination of the ILPS funds. This will vary according to the structure of the particular pension scheme s liabilities, and their investment return requirements. In addition, due to the leveraged nature of the ILPS funds, we do not expect investors to invest all of their assets 8 into the ILPS funds. The hedging requirements, the amount to be invested and the allocation between the ILPS funds will be determined by each investor. Investors in the ILPS funds should be aware of the following: Funding basis mismatch The Target Liability Profiles will be discounted using interest rate and inflation swap-derived discount curves (the hedging basis ). This may give rise to basis risk (the difference between the investor s actuarial funding basis and the hedging basis used by Standard Life Investments). Performance differences The following types of outcomes may be experienced by investors: The overall performance of the ILPS fund may differ from expected. For example, an ILPS fund may deliver a negative return despite the Growth fund having met its target return. This could be the case when the Hedge portfolio delivers a negative return due to changes in the market environment (i.e. changes in interest rates and/or inflation). The Hedge portfolio s performance may differ from the Target Liability Profile comparator performance. The discretionary implementation of the Hedge portfolio, including the use of a combination of swaps or gilt based instruments, could lead to material short-term performance differences relative to the performance of the Target Liability Profile as measured on the hedging basis. In addition, the longest-dated cashflows are longer-dated than the maturity dates of the longest-dated liability hedging instruments currently available in the market, which will necessarily cause some mismatch. The second element will be mitigated by monitoring that the overall duration of each Hedge portfolio remains within tolerance levels compared with the discounted Target Liability Profiles. Counterparty risk and collateral management The use of unfunded instruments introduces the need to have robust processes for both counterparty risk and collateral management. Standard Life Investments has risk controls in place for the use of derivatives for risk management and efficient portfolio management. Investors should also be aware that the ILPS funds are not providing: Tailored liability matching The use of a representative set of cashflows (the Target Liability Profile) may introduce profile risk. This is the difference between the investor s actual liability profile and the representative profile defined by Standard Life Investments. Cash flow management The ILPS funds will not provide income (redemption proceeds are only distributed during a Releverage Event). If investors want to use the ILPS funds to service liability cash flows, they will be required to do this by selling units in the funds. As well as reducing the asset value invested in the ILPS solution, this will reduce the amount of liability hedging being provided by the ILPS funds. 8 As we would not normally expect pension schemes to hedge significantly over their asset value, with an expected upper bound at their liability value.
Visit us online aberdeenstandard.com Important Information Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments. Unless otherwise indicated, this document refers only to the investment products, teams, processes and opinions of Standard Life Investments as at the date of publication. Please note that this document is for information only and any investors wishing to invest in the ILPS funds should review the Standard Life Investments Liability Solutions ICAV Prospectus and relevant Supplements in their entirety and consult with their legal, tax and financial advisers before deciding whether to make any investment in the ILPS funds. Investors should be aware of the following general risks: The value of investments may go down as well as up. An investor may get back less than they invested. Funding levels may go down as well as up. Past performance is not a guide to the future. Any data contained herein which is attributed to a third party ( Third Party Data ) is the property of (a) third party supplier(s) (the Owner ) and is licensed for use by Standard Life**. Third Party Data may not be copied or distributed. Third Party Data is provided as is and is not warranted to be accurate, complete or timely. To the extent permitted by applicable law, none of the Owner, Standard Life** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates. **Standard Life means the relevant member of the Standard Life group, being Standard Life plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time. Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. It is authorised and regulated in the UK by the Financial Conduct Authority and is the Investment Adviser and Distributor for Standard Life Investments Liability Solutions ICAV. Aberdeen Standard Investments Luxembourg S.A is a company incorporated under the laws of the Grand Duchy of Luxembourg and having its registered office at 35a, avenue John F. Kennedy, L-1855 Luxembourg, Grand Duchy of Luxembourg. It is authorised in Luxembourg and regulated by the CSSF and is the Authorised Investment Fund Manager for Standard Life Investments Liability Solutions ICAV. Standard Life Investments Liability Solutions ICAV is regulated by the Central Bank of Ireland and is an open-ended umbrella fund with segregated liability between sub-funds registered in the Republic of Ireland (no. C142122) at 70 Sir John Rogerson s Quay, Dublin 2, Ireland. www.aberdeenstandard.com 2018 Standard Life Aberdeen, images reproduced under licence Standard Life Investments Integrated Liability Pensions Solution 121035384_BRO_FUND_GUIDE