SCOTTISH WIDOWS PREMIER PENSION INVESTMENT APPROACHES CONCEPT AND DESIGN

SCOTTISH WIDOWS PREMIER PENSION INVESTMENT APPROACHES CONCEPT AND DESIGN

INTRODUCTION BUILDING ON THE SCOTTISH WIDOWS PENSION INVESTMENT APPROACHES, THE PREMIER PENSION INVESTMENT APPROACHES AIM TO OFFER BETTER POTENTIAL RETURNS FOR BROADLY THE SAME LEVELS OF RISK Our Scottish Widows Premier Pension Investment Approaches are part of our Premier Pension Fund range (Premier range), which is made up of: Premier Pension Investment Approaches (PPIA) lifestyling options primarily for employees who are members of group pensions. Premier Governed Investment Strategies (PGIS) lifestyling for Retirement Account customers. Premier Pension Portfolio Funds a range of eight multi-asset funds available to all Scottish Widows group pensions customers, Retirement Account customers and customers in selected other pension products. They are not available to Stakeholder customers. THE PREMIER RANGE: THE RATIONALE The Premier range builds on our well-established original range of Pension Investment Approaches (PIA), Governed Investment Strategies (GIS) and Pension Portfolio Funds. We carried out extensive modelling when we designed PPIA and PGIS and the underlying funds. This modelling projected that the Premier range of funds could have the potential to deliver better annual returns than our original passively-managed options, for broadly similar levels of risk. Please note this isn t guaranteed. Scottish Widows launched the PIA lifestyling option for group pensions in 2006. This was followed by our equivalent GIS for Retirement Account customers in 2010. In both cases, the Pension Portfolio Funds have been effective underlying investment vehicles. We continue to believe in these passively managed options as a robust and cost-effective approach to investing, and these investment options will continue to be available. However, as a result of significant developments within pensions, we believe that customers will demand more from their investments. This is why we launched the Premier range. The Premier range was introduced largely in response to the Pension Freedoms which came into force in April 2015. Because we believe defined contribution pensions are now likely to make up a significant, and growing, proportion of individuals pension provision in the UK, our opinion is that the level of net returns is going to become increasingly important. By introducing a carefully selected mix of new asset classes, management techniques and specialist investment strategies, we believe the Premier range has the potential to produce superior returns for broadly the same level of risk as our original, passively managed versions. More asset classes means there are more options for asset allocation decisions. And the more diversified range of assets should help to smooth the journey to retirement by helping to reduce the impact of large falls in any one market or asset class on customers investments. We believe that many of our pension customers will be prepared to pay more per year than for our original PIA and GIS options, to gain access to a greater range of asset classes and investment strategies that are still not widely available to individual investors. Pensions are a long-term investment. The retirement benefits you receive from your pension plan will depend on a number of factors including the value of your plan when you decide to take your benefits which isn t guaranteed, and can go down as well as up. The value of your plan could fall below the amount(s) paid in. For more information on our Premier Pension Investment Approaches please speak to your financial adviser. 1

DEVELOPING THE CONCEPT The main difference between our original, passively managed portfolios and the Premier range is the increased diversification that gives the Premier range greater investment scope. The Scottish Widows Asset Allocation team conducted extensive research to find out if diversification could potentially boost investment returns without increasing risk. Their modelling indicated an increase in potential returns within each Premier Pension Portfolio Fund compared to the original Pension Portfolio Funds. The initial assumptions for long-term returns on asset classes were provided by quantitative modelling specialists Moody s Analytics. Whilst they were involved in this initial stage, this was only the start of the process of constructing the Premier range. Our Asset Allocation team applied their own judgment to those of Moody s Analytics assumptions to reflect our view of expected long-term returns. And further modelling produced draft allocations, which were then tested to understand what would drive investment returns. Building on our original Pension Portfolios To establish the asset allocations for the Premier range, our Asset Allocation team built upon the model portfolios and glide path strategies we first developed for the original Pension Portfolios and passively managed PIA and GIS lifestyling options. We ran a large number of different scenarios that could affect the funds, including the impact of varying economic and market conditions and the probability of how this would affect the assets and strategies of the funds. We also allowed for the difference in fund charges between the Premier Pension Portfolio Funds and the Pension Portfolio Funds. Some of the key objectives of the modelling exercise included: creating Premier Pension Portfolio Fund portfolios that closely align to the risk profile of the corresponding Pension Portfolio Funds forecasting an extra annual return relative to the corresponding Pension Portfolio Funds (net of extra fees and costs) refining potential portfolios to achieve a mix of different risk and return drivers and to actively control costs. Our conclusion was that the Premier Pension Portfolio Funds could potentially achieve all this by accessing a selected mix of specialised investment strategies, a broad range of asset classes and an element of active management. The Premier range is able to target higher expected returns with similar levels of risk to the original, passively-managed range because the Premier range has the potential to harness the benefits of greater diversification by using a wider array of asset classes. Giving the Premier range greater scope The Premier Pension Portfolios build on the core strategies offered in our passively managed lifestyling options for PIA and GIS which will continue to be available. The key difference for our Premier lifestyling versions is that we use our new Premier Pension Portfolio Funds as the main underlying funds. These have been primarily created for this purpose and invest in assets and strategies other than traditional equities and bonds. Because we don t have an in-house manager, we can be objective about which asset managers to work with and this gives us the freedom to give the Premier range greater investment scope. We added significantly more investment components to the Premier range. These include relatively new concepts like Smart Beta strategies (including Fundamental Index Equities and Low Volatility Equities), along with more established strategies such as Absolute Return. We also added Property investment, Commodities and Tactical Asset Allocation. Keeping costs down Managing costs is an important factor. Some multimanager funds tend to take a relatively short-term view of asset allocation and frequently rotate fund managers. In contrast, the Premier range will take a more longterm approach, because switching managers can be expensive. By aiming to hold positions longer, we are able to negotiate competitive deals with fund providers. The longer-term strategic asset allocation of the Premier Pension Portfolio Funds will be reviewed annually, based on the three-to-five year house view agreed by our investment committee and specific proposals made by our Asset Allocation team. We use Tactical Asset Allocation to take into account shorterterm opportunities in markets and increase or reduce exposures to specific asset classes or markets based on how we expect them to perform. 2

THE MAIN FEATURES OF THE ASSET ALLOCATION The wider range of asset classes in the Premier range makes it possible to take more risk in each portfolio by reducing the overall exposure to fixed income. To help us maintain both potentially strong returns and reduce risk, we have also been able to reduce the reliance on equity market performance compared to our Pension Portfolio Funds by making use of commercial property and absolute return funds. We also have the capability to help reduce risk by moving some of the portfolios away from particular markets and asset classes when the returns look unattractive. Here we look at the main elements of our Premier Pension Portfolio Funds. 1. We favour a Smart Beta approach to equity investing We think Smart Beta has the potential to outperform traditional mainstream passively managed funds. Because traditional passive funds invest according to market capitalisation (in other words the total share value of a given company at that time), they tend to end up being concentrated in the largest and potentially most expensive companies. But Smart Beta indices aim to lower this tendency to chase winners by automatically selling stocks that appear fully valued and buying stocks that look undervalued. They can also help decrease volatility, especially when equity markets are under stress. The Smart Beta strategies we ve employed in the Premier Pension Portfolio Funds are Research Affiliates Fundamental Index (RAFI) and Low Volatility funds. The FTSE RAFI Fundamental Indices: Crucially, fundamental indices can avoid getting sucked into share price bubbles when a stock s market capitalisation rises to levels unjustified by its economic fundamentals. Research has indicated that fundamental indices have tended to outperform more traditional equity indices over the long term, by selling stocks when their share prices have overtaken their fundamentals and buying stocks when their share prices have fallen below their fundamental value. Please note that past performance is not an indicator of future results. The FTSE RAFI Low Volatility Indices: These low volatility indices complement the RAFI Fundamental Indices. Constructed using stocks with historically low levels of volatility and strong fundamental indicators such as book value, sales, cashflow and dividends low volatility indices are designed to outperform more mainstream indices during falling markets. Although they may trail standard equity indices when markets are rising, the downside protection that low volatility investing can provide in falling markets generally outweighs the same degree of outperformance in rising markets, in the long term. Historically, they have outperformed higher-volatility shares over the long term. Please note that past performance is not an indicator of future results. 2. Maintaining an allocation to UK Equities The RAFI Fundamental and Low Volatility Indices provide some exposure to the UK market. But given the importance and familiarity of the UK s domestic equity market to our customers, we have chosen to complement this with an additional passive allocation to the Scottish Widows All-Share Tracker Fund. This Scottish Widows fund is designed to replicate the FTSE All-Share Index, which tracks the broad UK equity market. The index includes around 650 listed companies and approximately 98% of the UK s total market capitalisation. Index Futures are an important tool within Premier, which we may use for both efficient portfolio management purposes and to gain exposure to certain asset classes. Futures contracts are an agreement to buy or sell an asset at a specified price at a particular point in the future. In the case of an equity index futures contract, the underlying asset is a stock market index, such as the FTSE 100. An investor will make a profit if the index is higher, at a particular point in time, than the price at which they had agreed to buy it, and vice versa. For a number of the Premier Pension Portfolios, we use futures to gain exposure to UK equities. 3

3. A preference for global investment-grade corporate bonds Corporate bonds can help reduce risk in a portfolio, as they are generally less volatile than many other asset classes and have the potential to offer a safe haven during times of stock market volatility. The Premier Pension Portfolio Funds will only invest in high quality global investment-grade corporate bonds. The fund we ve chosen for the Premier Pension Portfolio Funds is the Scottish Widows Corporate Bond 1 Fund. It s an actively managed fund that draws on Aberdeen Asset Management s global network of fixed-income professionals. Investing globally provides an additional element of diversification and enables its managers to be more selective. Please note that this fund is different to the Scottish Widows Corporate Bond Fund (Life & Pension). For more information on the Scottish Widows Corporate Bond 1 Fund, please contact your financial adviser or Scottish Widows. 4. Using property as a substitute for fixed income to potentially reduce volatility To potentially reduce portfolio volatility the Premier Pension Portfolio Funds use commercial property as well as corporate bonds. Long-term leases and the potential for sustainable rental income generally mean that property should be less volatile than equities. And it also helps increase diversification. Besides offering the potential for attractive long-term returns, property is less vulnerable to interest rate risk than traditional fixed income investments, as it is a real asset. Because rent reviews tend to be upwards and some rental agreements are explicitly inflationlinked, property can provide a degree of protection from inflation. The two property funds we chose for the Premier range are: The Scottish Widows Pooled Property ACS Fund 1, which is an actively managed direct property fund that invests in physical property such as shops, offices and warehouses. The BlackRock Global Property Securities Equity Tracker Fund, which is an indirect property fund that invests in the shares of quoted property companies. It will provide well diversified, low-cost and liquid exposure to shares of listed property companies and Real Estate Investment Trusts (REITs) in a wide range of global property markets. 5. Absolute Return funds can help reduce risk by increasing diversification To reduce exposure to equity markets and help to lower risk, we use absolute return funds. With their multi-strategy approach and dynamic asset allocation, absolute return funds give our customers access to assets that they might not otherwise be able to invest in. Absolute Return funds can invest in a wide range of investments and, although they may produce lower returns than equities when markets are rising, their focus on positive returns throughout the cycle should help to reduce portfolio risk. By capturing more of the market s gains than its losses, they have the potential to produce consistently positive returns over the long term. The two specialist Absolute Return funds we ve chosen the Insight Global Absolute Return Fund and the Nordea Diversified Return Fund have historically produced returns that lie somewhere between the return on bonds and equities. Please note that past performance is not an indicator of future results. 4

6. Using active fund managers selectively, to reduce costs To help control costs, we use active management selectively. The Premier range will make allocations to active fund managers with expertise and longstanding track records in managing assets, such as UK commercial property, absolute return and global corporate bonds. The Scottish Widows Emerging Markets Fund is an actively managed fund that invests in companies that are either based in the developing world or have a significant portion of their business activities there. As the developing world s stock markets are typically less efficient and under-researched than those of the developed world, experienced managers with good local knowledge can uncover attractive opportunities that passive strategies could fail to exploit. Strategies Equities Absolute Return Strategies Corporate Bonds (Investment Grade and High Yield) Property Tactical Asset Allocation Commodities Passively Managed Smart Beta Fundamental Index Equities (Developed Market, Emerging Market) Low Volatility Equities (Developed Market, Emerging Market) 5

HOW ARE THE PREMIER PENSION PORTFOLIO FUNDS INVESTED? We use a wide range of assets and investment strategies within the Scottish Widows Premier Pension Portfolio Funds. The table below shows the asset split by Premier Pension Portfolio Fund: SW PREMIER PENSION PORTFOLIOS 1 2 3 4 A B C 5 Building Blocks % % % % % % % % UK EQUITIES 14.80 14.80 15.10 11.50 14.90 14.40 7.90 0.00 Scottish Widows All Share Tracker Fund FTSE 100 Index Futures* GLOBAL DEVELOPED EQUITY 58.70 49.10 41.60 14.60 31.70 22.30 9.80 0.00 SWUTM Fundamental Index Global Equity Fund SWUTM Fundamental Low Volatility Index Global Equity Fund EMERGING MARKET EQUITY 18.30 14.80 12.20 4.20 9.00 6.70 2.00 0.00 Scottish Widows Emerging Markets Fund SWUTM Fundamental Low Volatility Index Emerging Markets Equity Fund SWUTM Fundamental Index Emerging Markets Equity Fund PROPERTY 0.00 7.10 8.70 10.30 8.80 10.30 9.80 0.00 BlackRock Global Property Securities Equity Tracker Fund Scottish Widows Pooled Property ACS Fund 1 GLOBAL INVESTMENT GRADE CORPORATE BONDS 0.00 1.90 7.60 37.10 18.10 27.60 48.10 0.00 Scottish Widows Corporate Bond 1 Fund HIGH YIELD BONDS 0.00 1.10 1.50 2.40 1.60 2.10 2.00 0.00 Scottish Widows High Income Bond Fund ABSOLUTE RETURN 8.10 10.00 11.40 16.30 12.90 14.40 18.00 0.00 Insight Global Absolute Return Fund Nordea 1 - GBP Diversified Return Fund COMMODITIES 0.00 0.80 1.30 2.00 1.60 1.80 2.00 0.00 Scottish Widows Alternatives Pension Fund SHORT MATURITY INVESTMENTS 0.10 0.40 0.60 1.60 1.40 0.40 0.40 100.00 24AM Senior Secured Bond Fund Insight LIBOR Plus Fund Aberdeen Liquidity Fund (Lux) Ultra Short Duration Sterling Fund Source: Scottish Widows, June 2017 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 *The UK equity component represents the fund s exposure to UK equities. Most of the fund s UK equity exposure is gained predominantly through investments in FTSE 100 Index Futures. The Scottish Widows Premier Pension Portfolio Funds 1, 2, 3 and 4 are the Premier equivalents of the Scottish Widows Pension Portfolio Funds 1, 2, 3 and 4 used in our original passively managed PIA and GIS versions. Premier Pension Portfolio Fund 5 is a specialised pre-retirement option. It plays a similar role within the PPIA and PGIS as Pension Portfolio Five and the Scottish Widows Cash Fund do in PIA and GIS. As a fund of funds, it invests in a range of underlying short maturity cash and fixed income funds, with the aim of improving returns within periods of rising and falling interest rates. Its asset allocation will be reviewed by the Scottish Widows Asset Allocation team on an ongoing basis and tactically adjusted depending on market conditions and investment outlook. 6

TACTICAL ASSET ALLOCATION Tactical asset allocation (TAA) involves adjusting the long-term asset allocation within a portfolio in order to capture shorter-term relative value opportunities in markets. We do not undertake TAA directly within Premier s portfolios but instead invest in Scottish Widows GTAA 1, which is a TAA fund managed on our behalf by Aberdeen Asset Management. This fund invests in equities, bonds, currencies and commodities using derivative instruments such as futures and forward currency contracts. One of the main advantages of investing in a TAA fund rather than implementing TAA decisions directly is that it reduces transactions and transaction costs as the underlying assets within our Premier Pension Portfolios are not being bought and sold. This in turn reduces the need for cash to fund transactions, which can be a drag on portfolio performance. Finally, it ensures consistency of execution across portfolios. SHORT DATED MATURITIES: PREMIER PENSION PORTFOLIO FUND 5 We invest in Short Dated Maturities through Premier Pension Portfolio 5 which is used as one of the specialised pre-retirement options for PPIA and PGIS propositions. A range of underlying fund holdings have been identified which we believe provides the flexibility to achieve the performance target throughout periods of rising and falling interest rates. As a fund of funds, Premier Pension Portfolio 5 invests in a blend of short dated fixed deposits, certificates of deposit, Floating Rate Notes (FRNs), Asset Backed Securities and short dated corporate notes. Some of these offer specific benefits not available from more traditional assets, such as floating interest rates (through FRNs), and physical collateral such as commercial and residential property provided as security for thousands of underlying loans within Asset Backed Securities. The allocation to the underlying funds will be reviewed and tactically adjusted depending on market conditions and investment outlook. The underlying funds we have selected are: TwentyFour Asset Managers Senior Secured Bond Fund we chose this fund because TwentyFour Asset Managers is a boutique fixed income asset manager specialising in Asset Backed Securities, with one of the largest dedicated ABS research teams in the UK. Insight LIBOR Plus Fund Insight are a subsidiary of BNY Mellon, with a reputation for excellence in active fixed income. Aberdeen Liquidity Fund (Lux) Ultra Short Duration Sterling Fund this fund has 4.7 billion in assets under management (as at 30 June 2017) and is managed by Aberdeen Asset Management s specialist money market team. It provides a broad range of eligible assets, including fixed deposits, certificates of deposit, floating rate notes and gilts. OUR OTHER SPECIALISED PRE-RETIREMENT FUND USED FOR PPIA AND PGIS TARGETING ANNUITY RETIREMENT OUTCOMES We use the Scottish Widows Pension Protector Fund as a specialised fund during the last five years of our PPIA and PGIS Targeting Annuity retirement outcomes. In combination with Premier Pension Portfolio 5, it s designed to prepare our Targeting Annuity customers pension pots for annuity purchase at retirement. The Scottish Widows Pension Protector Fund invests mainly in long-dated UK fixed interest securities. CONCLUSION The Premier Pension Portfolio Funds aim to deliver higher returns, on a net of fee basis, at similar levels of investment risk to the Pension Portfolio range and original PIA and GIS lifestyling options. Scottish Widows modelling suggests that it could achieve this using more dynamic asset allocation and introducing new asset classes, including Absolute Return funds, low volatility equities and property. We have carried out a selection exercise for each asset class, taking into account fund manager capability, cost and fit with the broader proposition. A key requirement was balancing the need to create portfolios that can provide a higher expected return relative to the Scottish Widows Pension Portfolio range against the need to ensure that the costs for the Premier Pension Portfolio Funds are kept within a reasonable charge level. Pensions are a long-term investment. The retirement benefits you receive from your pension plan will depend on a number of factors including the value of your plan when you decide to take your benefits which isn t guaranteed, and can go down as well as up. The value of your plan could fall below the amount(s) paid in. There are charges associated with investing in the funds. The charges can be different for different funds and can change. For details of the charges, please contact your financial adviser or Scottish Widows. Full terms and conditions are available on request from Scottish Widows. Charges, terms and limits may change. 7

Scottish Widows Limited. Registered in England and Wales No. 3196171. Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number 181655. 55405 07/17