GOVERNED INVESTMENT STRATEGIES (GIS) GOVERNANCE REVIEW 2017 FULL REPORT This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.
As part of our rigorous governance processes for our core Governed Investment Strategies, we carry out regular governance reviews. This latest full review aims to maintain an effective asset allocation for each risk profile, building on a long period of strong performance.
PAGE 2 INTRODUCTION PAGE 3 SUMMARY OF 2017 RECOMMENDATIONS PAGE 4 SCOPE OF THE REVIEW PAGE 6 THE REVIEW IN DETAIL PAGE 10 WHAT THE REVIEW MEANS FOR OUR GOVERNED INVESTMENT STRATEGIES PAGE 12 FURTHER DETAILS ON OUR GOVERNED INVESTMENT STRATEGIES 1
INTRODUCTION AT THE CORE OF OUR RETIREMENT ACCOUNT INVESTMENT PROPOSITION ARE OUR THREE GOVERNED INVESTMENT STRATEGIES: ADVENTUROUS BALANCED CAUTIOUS THEY ARE DESIGNED AS A LOW-COST, TRANSPARENT PROPOSITION REFLECTING CUSTOMERS DIFFERENT ATTITUDES TO RISK AND REWARD. For more detail see the section: FURTHER DETAILS ON OUR GOVERNED INVESTMENT STRATEGIES. When the Governed Investment Strategies (GIS) were launched in 2010, they incorporated our existing rigorous and ongoing governance process, which included input from independent specialists. Part of this governance process is to carry out regular reviews. The purpose of each review is to ensure that our GIS, and their strategic asset allocation, maintain the potential to provide good investment outcomes for our customers at the intended risk profile. We would add that, in reviewing the GIS, we do not see any advantage in regularly tinkering with their allocation, with associated costs of turnover. Changes are made only when we consider them materially positive for the outlook of the GIS. Our latest review was completed in early 2017, and is summarised in this document. It was undertaken by our Investment Strategy & Execution team, using stochastic modelling tools provided by Moody s Analytics. The results of the analysis were presented to and approved by our Unit Linked Investment Management (ULIM) Committee in March 2017. ULIM s role is to govern all unit linked funds, ensuring they meet our commitments to customers. 2
SUMMARY OF 2017 RECOMMENDATIONS As a result of this governance review, the principal changes are to: 1 Remove index-linked gilts from Pension Portfolios Three and Four in favour of corporate bonds 2 Diversify the corporate bond allocation by reducing the sterling bond exposure from 100% to 75%, and balancing this by introducing an allocation of 25% to global corporate bonds 3 Hedge the new global corporate bond element back to sterling. The overseas equity component remains unhedged 4 Introduce a small allocation to emerging markets to Pension Portfolio Four in line with other portfolios The recommendations and rationale leading to these changes are discussed on page 11. 3
SCOPE OF THE REVIEW 4
CHANGES TO THE BASIS OF THE 2017 REVIEW With all three GISs, a customer s pension fund will gradually move into lower-risk investments in the 15 years prior to retirement. This lifestyle switching process is intended to protect the value of the fund from large fluctuations in market movements in the years leading up to retirement. In response to the implementation of Pension Freedoms legislation in April 2015, we introduced additional investment retirement outcomes for the GIS. These are designed to prepare customers for different retirement options; take cash from their pension, remain invested or purchase an annuity. The different options start to diverge at five years before retirement. All three retirement outcomes assume that customers will take a tax-free cash sum at retirement, so in each case, 25% of the pot is switched into cash-like investments over the course of the five years before retirement. More detail about the retirement outcomes is shown in the FURTHER DETAILS ON OUR GOVERNED INVESTMENT STRATEGIES section. These new retirement outcomes represent a significant change in our approach since the previous governance reviews for the GIS, and are now reflected in our review and modelling processes. Customer behaviour following the Pension Freedoms reforms shows that the most popular of the three options, by a considerable margin, is to remain invested post-retirement. Throughout the review, a 25-year Targeting Flexible Access customer was used as the central or default strategy when we developed our recommendations. This incorporates 10 years of growth and 15 years of de-risking. We also tested different scenarios for a Targeting Flexible Access customer with 15 years to retirement. Whilst the Targeting Flexible Access retirement outcome is the central focus of this review and its recommendations, we also tested whether asset allocations that produced positive outcomes for this option would lead to any detrimental consequences for the Targeting Annuity outcome. For those customers Targeting Encashment, we will continue to move their investment uniformly to the Cash Fund over the five years to retirement. FURTHER REVIEW BACKGROUND The review took place against a background of strong performance (absolute and relative) across the GIS. We are proud of their track record and the value they have delivered for customers. This review is intended to maintain and improve their effectiveness and performance, ensuring they are optimally set up to deliver good results while adhering to their defined risk profiles. Its scope was designed to rigorously: 1. Adjust the asset allocation and glidepaths where there is opportunity to improve projected return, while maintaining broad alignment to the ABI sector risk levels. 2. Review the current UK to overseas equity split. 3. Consider the regional breakdown for overseas equity. 4. Assess the impact of changing the bond composition. 5. Analyse the long-term impact of hedging overseas asset exposure. All testing was based on the existing asset classes for the GIS, which offer a transparent, low-cost proposition based on equities (passive), corporate bonds (passive), gilts and cash. The modelling for the review was carried out using Moody s Analytics stochastic financial modelling tools. Our asset allocation approach Governance reviews for our GIS are focused on the strategic asset allocation (SAA) of the funds. Our SAA considers the optimal mix of asset classes and regional breakdowns for each risk profile, based upon their modelled returns over the long term (taking into account that the GIS, as low-cost vehicles, focus on a concentrated range of assets). In 2015, we enhanced our in-house capability, and as part of this established a dedicated Asset Allocation team. In addition to determining the long-term strategic asset allocation of our multi-asset pension funds, the team looks for medium-term opportunities. By reflecting these in the portfolio, we aim to create additional value, though SAA is still the main driver of the GIS. This means that periodically the team will identify medium-term (which we broadly define as 18 months to five years) positions that could add value without taking funds outside their targeted risk tolerance. Ongoing monitoring of volatility Our regular governance reviews for the GIS take place in addition to the ongoing performance monitoring and governance activity we do for all funds used in our Pension Portfolios One, Two, Three and Four, which underlie the GIS (see the section FURTHER DETAILS ON OUR GOVERNED INVESTMENT STRATEGIES for the asset splits of these Portfolios and a summary of how they are used within our GIS). This monitoring encompasses assessment of the realised volatility of these portfolios, in order to determine that it is in line with expectations. Like the full governance review, this monitoring of realised volatility helps to ensure that our GIS, and their underlying Portfolios, continue to meet their aims and objectives, and maintain the potential to provide good outcomes for our customers. 5
THE REVIEW IN DETAIL 6
1 ADJUST THE ASSET ALLOCATION AND GLIDEPATHS WHERE THERE IS OPPORTUNITY TO IMPROVE PROJECTED RETURN, WHILE MAINTAINING BROAD ALIGNMENT TO THE ABI SECTOR RISK LEVELS When reviewing each of our GISs, we assess their risk and return profile by comparison to the three ABI managed fund sectors. ADVENTUROUS BALANCED CAUTIOUS ABI Flexible Investment ABI Mixed Investments 40% 85% Shares ABI Mixed Investments 20% 60% Shares Our objective is for the GISs to provide a similar level of risk to these sectors (as measured by the projected outcome of the 95th percentile ie the fifth worst outcome of 100 scenarios modelled). Given that these industry benchmarks are well understood in the marketplace and representative of a wide universe of funds, they offer an effective and consistent measure for comparing the risk and return profile of our GIS. Our governance objective is to compare the risk of each GIS with the chosen ABI sector and to consider options to broadly align these if there is a material discrepancy. Each governance review aims to refine the long-term strategic asset allocation of the GIS, while avoiding changes that show only limited positive impacts. The intention is to improve projected returns while avoiding unnecessary transaction costs and ensuring that the GIS retain their intended risk positioning. In testing the risk profiles of the GIS glidepaths, our objective in this review is to broadly align where possible, and where we can at least maintain projected returns the risk profile of our Balanced GIS glidepath with that of the corresponding ABI sector benchmark. Once we are comfortable with the positioning of the Balanced GIS, we assess the Adventurous and Cautious GISs to ensure they are appropriately positioned relative to Balanced, whilst similarly looking at their positioning relative to the ABI benchmarks. We also aim to have consistent and coherent asset allocation changes applied across all GISs and their underlying portfolios. Outcome For each of the three glidepaths, the measures taken will slightly reduce modelled risk to align to the appropriate ABI sector, while producing higher expected returns over 25 years. 7
2 REVIEW THE CURRENT UK TO OVERSEAS EQUITY SPLIT The review tested a number of equity asset allocations for each GIS glidepath, exploring whether the UK/ overseas equity split could be optimised. It modelled shifts of 5% and 10%, in both directions, in the UK/ overseas split. These were rejected given that the slight increase in forecast return was not justified by the increased level of risk. Also modelled was the effect of introducing an allocation to emerging markets to Pension Portfolio Four (a portfolio which all the glidepaths use in their later stages). The previous full governance review introduced emerging market equity to Pension Portfolios One, Two and Three, but not to Pension Portfolio Four. Outcome The modelling carried out for this current review showed that adding a small 2% allocation of emerging markets equity to Pension Portfolio Four would provide a small improvement to the expected risk-adjusted returns achieved over a long-term, strategic horizon and achieve greater consistency across the Portfolios. We have therefore decided to align the global equity structure of Pension Portfolio Four with that of Pension Portfolios One, Two and Three. 3 CONSIDER THE REGIONAL BREAKDOWN FOR OVERSEAS EQUITY The review explored different regional breakdowns within the allocation for overseas equity. As with the other elements of the review, this was modelled for a range of retirement strategies, including Targeting Flexible Access and Targeting Annuity outcomes. Targeting Flexible Access was used as the default scenario. Outcome The review tested a number of regional breakdowns for overseas equity, for each GIS and its ABI sector benchmark. None was found likely at present to significantly improve the overall long-term risk/return profiles of the three Approaches. 8
4 ASSESS THE IMPACT OF CHANGING THE BOND COMPOSITION As with the other elements in this review, we modelled a variety of asset allocation themes in order to assess the impact of changing the bond asset composition. The inclusion of global corporate bonds in the GIS was found to improve the risk-adjusted return. At the same time, we modelled the removal of index-linked gilts from the asset allocation. We found that the long-term forecast for this asset class is poor, with low risk-adjusted returns expected, reflecting current negative real yields. Furthermore, the previous role of index-linked gilts was based on the scenario, pre-pension Freedoms, where annuity purchase was the default option for our customers. Following Pension Freedoms, with Targeting Flexible Access now the central scenario and most annuity customers taking a level annuity, the argument for index-linked gilts is less persuasive. The analysis, based on testing the default Targeting Flexible Access retirement outcome and also the Targeting Annuity option, therefore strongly indicated in favour of the introduction of global corporate bonds, and at the expense of index-linked gilts where these were in portfolios. The balance of allocation to global corporates will come from UK corporates. Outcome This result was the most significant finding of the review in terms of recommended changes to the portfolios. We have therefore decided to remove index-linked gilts in favour of corporate bonds and switch the corporate bond allocation to 25% global corporate bonds (hedged to sterling) and 75% GBP corporate bonds (from 100% GBP). We may consider further switches towards global at future reviews. 5 ANALYSE THE LONG-TERM IMPACT OF HEDGING OVERSEAS ASSET EXPOSURE Our research and modelling shows no evidence that currency hedging overseas equities would improve long-term projected returns for the GIS. Long-term studies show no material difference between the returns on hedged and unhedged overseas equities. Indeed, there is evidence that equity markets adjust, at least in part, for relative currency changes. On that basis, we have decided not to change our long-term position and will remain unhedged on non-uk equities. Outcome The position for hedging the global corporate bond component is different. The key uplift expected from this move is the diversification of expected sources of credit risk return leading to both lower risk and better returns. Currency exposure would be a separate risk within this, given that there is less evidence of adjustment in that sector to currency changes. We have therefore decided not to increase the overall level of currency exposure in the GIS from current levels, and, as the GIS glidepaths are intended to achieve stability, we will hedge overseas fixed-income returns to sterling. 9
WHAT THE REVIEW MEANS FOR OUR GOVERNED INVESTMENT STRATEGIES 10
Our modelling showed that a switch from index-linked gilts, and to a lesser extent from UK corporate bonds, to a fixedincome component of 25% global corporate bonds (hedged to sterling) and 75% GBP corporate bonds improves the projected risk/return profiles for all our GISs. It also brings them closer to their benchmark ABI fund sectors. The introduction of 2% emerging markets exposure in Pension Portfolio Four also adds a small improvement to the projected risk/return profile of the GIS. The projected aggregate benefits from these switches, in terms of how they improve both the risk and the return elements of their risk/return profile are shown in this section. Following the changes, they also have a closer alignment with the ABI benchmark funds. 'REMAIN INVESTED' PROJECTIONS 25 YEARS TO RETIREMENT Cash Value Nominal at 50th Percentile ( k) 440 420 400 380 360 340 230 220 ABI Adventurous Glidepath ABI Balanced Glidepath ABI Cautious Glidepath Increasing Risk to Right. Predicted value of lower 5th percentile / 95th percentile 210 200 BALANCED Targeting Flexible Access CAUTIOUS Targeting Flexible Access 190 ADVENTUROUS Targeting Flexible Access 180 Cash Value Nominal 95% VaR ( k) Adventurous GIS position: prior to this review following this review Balanced GIS position: prior to this review following this review Current ABI Glidepath position Cautious GIS position: prior to this review following this review Source: 2017 The chart shows the projected impact for a Targeting Flexible Access customer with 25 years to retirement (10 years of growth and 15 years of de-risking). Our analysis showed that the proposed changes would also have a beneficial impact for customers on Targeting Annuity and Targeting Encashment strategies. All recommendations made in this review relate to a long-term horizon, rather than immediate tactical gains. In implementing them, we will take into account factors such as the scale of the assets under management, market timing and condition, and the possibility of effecting changes gradually through the investment of inflows rather than switches, which will minimise the trading cost impact on fund returns. We believe the recommendations discussed in this report will further enhance our Governed Investment Strategies, which remain a low-cost and transparent investment proposition for group pensions. The GIS have already delivered strong absolute and relative performance over a sustained period, and produced good value for customers. The asset allocation changes proposed in this governance review all based on rigorous modelling are designed to maintain the portfolios potential to provide strong customer outcomes within their stated risk category. 11
FURTHER DETAILS ON OUR GOVERNED INVESTMENT STRATEGIES The full range of options under our Governed Investment Strategies is as follows: ADVENTUROUS RISK CATEGORY BALANCED RISK CATEGORY CAUTIOUS RISK CATEGORY Adventurous (Targeting Annuity) Balanced (Targeting Annuity) Cautious (Targeting Annuity) Adventurous (Targeting Encashment) Balanced (Targeting Encashment) Cautious (Targeting Encashment) Adventurous (Targeting Flexible Access) Balanced (Targeting Flexible Access) Cautious (Targeting Flexible Access) DEFINITIONS Targeting Annuity for those planning to buy an annuity to provide a fixed income for life. Targeting Encashment for those who plan to encash their fund. Targeting Flexible Access for those who wish to remain invested as they plan to access their pension on a more flexible basis. 12
The tables below and on page 14 show the target split for each of our Governed Investment Strategies: Adventurous, Balanced and Cautious. The tables show how each is invested at key points along the road to retirement. Adventurous (Targeting Annuity retirement outcome) Balanced (Targeting Annuity retirement outcome) Highest risk Lowest risk Highest risk Lowest risk Years to Retirement Target Split of Investments Used Overseas Shares 15 yrs+ 75% 25% UK Shares Bonds Cash* 10 yrs 63.8% 21.2% 15% 5 yrs 52.5% 17.5% 30% 0 yrs 75% 25% Years to Retirement Target Split of Investments Used Overseas Shares UK Shares Bonds Cash* 15 yrs+ 63.8% 21.2% 15% 10 yrs 52.5% 17.5% 30% 5 yrs 30% 10% 60% 0 yrs 75% 25% Adventurous (Targeting Encashment retirement outcome) Balanced (Targeting Encashment retirement outcome) Highest risk Lowest risk Highest risk Lowest risk Years to Retirement Target Split of Investments Used Overseas Shares 15 yrs+ 75% 25% UK Shares Bonds Cash* 10 yrs 63.8% 21.2% 15% 5 yrs 52.5% 17.5% 30% 0 yrs 100% Years to Retirement Target Split of Investments Used Overseas Shares UK Shares Bonds Cash* 15 yrs+ 63.8% 21.2% 15% 10 yrs 52.5% 17.5% 30% 5 yrs 30% 10% 60% 0 yrs 100% Adventurous (Targeting Flexible Access retirement outcome) Balanced (Targeting Flexible Access retirement outcome) Highest risk Lowest risk Highest risk Lowest risk Years to Retirement Target Split of Investments Used Overseas Shares 15 yrs+ 75% 25% UK Shares Bonds Cash* 10 yrs 63.8% 21.2% 15% 5 yrs 52.5% 17.5% 30% 0 yrs 22.5% 7.5% 45% 25% Years to Retirement Target Split of Investments Used Overseas Shares UK Shares Bonds Cash* 15 yrs+ 63.8% 21.2% 15% 10 yrs 52.5% 17.5% 30% 5 yrs 30% 10% 60% 0 yrs 22.5% 7.5% 45% 25% 13
Years to Retirement Cautious (Targeting Annuity retirement outcome) Highest risk Target Split of Investments Used Overseas Shares UK Shares Bonds Cash* 15 yrs+ 52.5% 17.5% 30% 10 yrs 30% 10% 60% 5 yrs 30% 10% 60% Lowest risk 0 yrs 75% 25% Cautious (Targeting Encashment retirement outcome) Years to Retirement Highest risk Target Split of Investments Used Overseas Shares UK Shares Bonds Cash* 15 yrs+ 52.5% 17.5% 30% 10 yrs 30% 10% 60% 5 yrs 30% 10% 60% Lowest risk 0 yrs 100% Cautious (Targeting Flexible Access retirement outcome) Highest risk Lowest risk Please note that, whichever fund is being invested in, the value of the investment can go down as well as up, and could fall below the amount(s) paid in. This also applies to cash and near-cash funds which invest in securities, as these securities can fluctuate more than a customer might expect. Cash or near-cash funds do not guarantee a positive return, nor do they provide complete protection for investments. *CASH AS AN ASSET CLASS Two of the funds we use in our Governed Investment Strategies invest in cash as an asset class. These funds are often referred to as simply cash or near-cash funds. Cash as an asset class (or as a type of fund) does not mean the same thing as money in a normal bank account. A cash fund may hold different types of cash-like assets that have similar characteristics to bank deposits such as a fixed rate of interest, quick access and low risk of capital loss. But an investment in a cash fund is not like putting money in a bank account. Cash funds mainly hold investments that mature (ie pay out) in the short term (weeks), but can hold assets with slightly longer periods to maturity. A longer period to maturity often means the fund manager is trying to earn a slightly higher return by taking a little more risk, which leads to the potential for slightly higher returns and risks than a bank deposit account. The fund will fluctuate in value because of, among other things, charges and possible falls in interest payments, so investors can get back less than they invest. There is also the risk that this type of fund will not keep pace with inflation. Years to Retirement Target Split of Investments Used Overseas Shares UK Shares Bonds Cash* 15 yrs+ 52.5% 17.5% 30% 10 yrs 30% 10% 60% 5 yrs 30% 10% 60% 0 yrs 22.5% 7.5% 45% 25% 14
For each of the GISs, the tables below show which funds are used for each risk category and each retirement outcome. ADVENTUROUS RISK CATEGORY 15 years+ at 10 years at 5 years at 0 years Adventurous (Targeting Annuity) Pension Portfolio 1 Pension Portfolio 2 Pension Portfolio 3 Pension Protector 75% Cash 25% Adventurous (Targeting Encashment) Pension Portfolio 1 Pension Portfolio 2 Pension Portfolio 3 Pension Portfolio 5 Adventurous (Targeting Flexible Access) Pension Portfolio 1 Pension Portfolio 2 Pension Portfolio 3 Pension Portfolio 4 75% Pension Portfolio 5 25% BALANCED RISK CATEGORY 15 years+ at 10 years at 5 years at 0 years Balanced (Targeting Annuity) Pension Portfolio 2 Pension Portfolio 3 Pension Portfolio 4 Pension Protector 75% Cash 25% Balanced (Targeting Encashment) Pension Portfolio 2 Pension Portfolio 3 Pension Portfolio 4 Pension Portfolio 5 Balanced (Targeting Flexible Access) Pension Portfolio 2 Pension Portfolio 3 Pension Portfolio 4 Pension Portfolio 4 75% Pension Portfolio 5 25% CAUTIOUS RISK CATEGORY 15 years+ at 10 years at 5 years at 0 years Cautious (Targeting Annuity) Pension Portfolio 3 Pension Portfolio 4 Pension Portfolio 4 Pension Protector 75% Cash 25% Cautious (Targeting Encashment) Pension Portfolio 3 Pension Portfolio 4 Pension Portfolio 4 Pension Portfolio 5 Cautious (Targeting Flexible Access) Pension Portfolio 3 Pension Portfolio 4 Pension Portfolio 4 Pension Portfolio 4 75% Pension Portfolio 5 25% 15
Following this governance review, the investments in the multi-asset Pension Portfolios underlying the GIS are proposed to change to the asset classes below. Asset classes Funds Overseas Equities - SSgA Europe ex UK Equity Index Fund - SSgA North America Equity Index Fund - SSgA Japan Equity Index Fund - SSgA Asia Pacific Ex Japan Equity Index Fund - SSgA Emerging Markets Equity Index Fund UK Equities - SSgA UK Equity Index Fund Corporate Bonds - SWUTM Corporate Bond Tracker Fund Global Corporate Bonds (hedged) - Aberdeen Global Corporate Bond Tracker Fund Cash - Aberdeen Liquidity Fund (Lux) Ultra Short Duration Sterling Fund - Aberdeen Global Liquidity Fund Sterling Sub Fund Pension Portfolio One Pension Portfolio Two Pension Portfolio Three Pension Portfolio Four 75.0% 63.8% 52.5% 30.0% 25.0% 21.2% 17.5% 10.0% 11.3% 22.5% 45.0% 3.7% 7.5% 15.0% Pension Portfolio Five 100% For more information on our investment funds visit: www.scottishwidows.co.uk/extranet/funds PLEASE REMEMBER PAST PERFORMANCE IS NOT AN INDICATOR FOR FUTURE RESULTS. INVESTMENT MARKETS AND CONDITIONS CAN CHANGE RAPIDLY AND, AS SUCH, ANY VIEWS EXPRESSED SHOULD NOT BE TAKEN AS STATEMENT OF FACT, NOR SHOULD RELIANCE BE PLACED ON THESE VIEWS WHEN MAKING INVESTMENT DECISIONS. 16
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