Statement of Investment Principles This is the Statement of Investment Principles (the Statement ) made by Hermes Pension Trustees Limited, as Trustee (the Trustee ) of the Hermes Group Pension Scheme ( the Scheme ) in accordance with the Pensions Act 1995 (as amended). The Statement follows on from the previous version prepared by the Trustee, in March 2017, to reflect additional changes made to the Scheme s investment strategy. The Statement is subject to periodic review at least every three years and without delay after any significant change in investment policy. In preparing this Statement, the Trustee has consulted with the Principal Employer to the Scheme (BT Pension Scheme Trustees Limited) and has taken and considered written advice from the Investment Practice of Hymans Robertson LLP. The Scheme is a defined benefit scheme which closed to further accruals on 31 October 2011 and to new members in 2008. Scheme objective The primary objective of the Scheme is to provide pension and lump sum benefits for members on their retirement and/or benefits on death, before or after retirement, for their dependants, on a defined benefits basis. The Trustee s over-riding funding principles for the Scheme are to set the employer contribution at a level which is sufficient: to recover any shortfall in assets relative to the value placed on accrued liabilities over the longer term; and to ensure that there are always sufficient assets of the Scheme (at their realisable value) to meet 100% of benefits as they fall due for payment to members. For employee members, benefits are based on service completed but take account of future salary increases. The value of liabilities is calculated on the basis agreed by the Trustee and the Scheme Actuary. The funding position is monitored regularly by the Trustee and formally reviewed at each triennial actuarial valuation, or more frequently as required by the Pensions Act 2004. Long-term investment objective The investment objective is to achieve a return on Scheme assets which (when taken in conjunction with contributions) is sufficient to match the Scheme s liabilities measured on a self-sufficiency basis by 2035. The Trustee will manage the Scheme with the long-term objectives in mind and will review these as appropriate, for example as part of triennial valuations of the Scheme. Investment strategy The Scheme s investment strategy has been reviewed in light of the above objectives and the revised strategic (asset allocation) benchmark for the Scheme is shown overleaf. This reflects activity since March 2017 at the portfolio level, in terms of derisking from equities to liability driven investments ( LDI ). The target allocation to equities has reduced from 30% to 20%, LDI has increased from 25% to 40%, and the multi-asset strategy allocation has reduced from 20% to 15%, compared to the positions at 31 March 2017. May 2018 001
Global Equity Passive, 16% EM Equity Active, 4% Multi-asset Strategy Active, 15% Property Income Active, 10% Diversified Credit Active, 15% LDI Passive, 40% The rationale behind this is to offer more efficient diversification, via the implementation of multi-asset funds, and better hedging of liability risk, through the use of liability driven investments. The simpler structure will also facilitate a greater focus on longer term strategy. The strategic benchmark is consistent with the Trustee s view on the appropriate balance between seeking an enhanced long-term return on investments and accepting greater short-term volatility and risk. The strategic benchmark is reflected in the choice and mix of funds in which the Scheme invests. The investment strategy takes due account of the maturity profile of the Scheme (in terms of the relative proportions of liabilities in respect of pensioners and deferred members), together with the level of disclosed surplus or deficit (relative to the funding bases used) and the Trustee s view of the covenant of the Principal Employer. It is expected that the strategic benchmark will be revisited as part of a further review of investment strategy over the coming 6-12 months. Over 2017, the Scheme has implemented partial currency hedging for its overseas equities by making an allocation, in September 2017, to GBP-hedged versions of existing global equity funds held (excluding emerging markets). This aims to achieve currency hedging of approximately 50% (for this part of the portfolio). In addition, in November 2017 the Scheme s assets in the LDI pooled funds were transferred into a Qualifying Investor Alternative Investment Fund (QIAIF) to facilitate a significant increase in the Scheme s interest rate and inflation hedging. The QIAIF allows greater flexibility in managing the LDI portfolio and invests in assets such as fixed interest and index-linked gilts, gilt and index-linked repurchase transactions and money market cash assets. The QIAIF is a bespoke fund in which the Trustee is the sole investor. Following the Flexible Apportionment Arrangement ( FAA ), the Scheme received a significant cash injection from the Principal Employer. In January 2018, most of this contribution together with a portion of the Scheme s equities which were sold, was invested into the QIAIF to increase the allocation closer to the revised targets shown above. The Trustee is currently considering investing in a new private debt mandate, within the diversified credit allocation. May 2018 002
The Trustee monitors the asset distribution relative to its agreed asset allocation benchmark, although it should be noted that the need to maintain the liability hedging strategy may mean that the asset mix is not always rebalanced back to the percentages shown above. In addition, the investment strategy may be updated over time, following Trustee review, to ensure the long-term investment objectives can continue to be met. The Trustee monitors the progress against the long-term objective and the performance of Scheme investments relative to agreed criteria on a regular basis. It is intended that investment strategy will be reviewed at least every three years following actuarial valuations of the Scheme, and will normally be reviewed annually. Written advice is received as required from professional advisers. The Trustee has delegated all day to day investment decisions to authorised investment managers. LDI Hedging Strategy A portion of the Scheme s interest rate and inflation exposure associated with the liabilities is hedged using the assets held in the bespoke QIAIF (i.e. LDI portfolio). At the end of 2017, the Trustee began the process to increase the Scheme s target proportion of liability hedging up to asset cover or the funding level. This is being undertaken using a time-based approach, with an overlay of yield triggers based on the yield on the 2047 gilt rising and breaching at pre-determined levels (at 2.2%, 2.4% and 2.6%). In the absence of any yield triggers being breached, the manager is phasing the increase in hedging on a quarterly basis, such that the target hedge ratio will reach 100% asset cover by 31 January 2019, from a starting target hedge ratio of 65% of assets. Choosing investments The Trustee has selected investment managers to manage Scheme investments, typically investing via pooled funds. All investment managers are authorised under the Financial Services and Markets Act 2000 to undertake investment business. The Trustee, after taking appropriate advice, has chosen funds with specific guidelines including, but not limited to, asset allocation and geographic spread, and how investment mandates are to be managed. The investment managers are allowed some flexibility of choice subject to their benchmarks and other guidelines and are expected to maintain diversified portfolios. The Trustee reviews the nature of Scheme investments on a regular basis, with particular reference to suitability and diversification. The Trustee seeks and considers written advice from a suitably qualified person in undertaking such a review. If, at any time, investment in a security or product not previously known to the Trustee is proposed, appropriate advice is sought (including necessary training) and considered to ensure its suitability and diversification. Kinds of investment to be held The Scheme may invest in quoted and unquoted securities of UK and overseas markets including, but not limited to, equities and fixed interest and index linked bonds, cash, property and commodities either directly or through pooled funds (including the QIAIF). The Scheme may also make use of contracts for differences and other derivatives (or invest in pooled funds investing in these products) for the purpose of efficient portfolio management or to hedge specific risks. The Trustee considers all of these classes of investment to be suitable for the circumstances of the Scheme. The funds that the Scheme is currently invested in are shown in the Appendix. Balance between different kinds of investments The Scheme s investment managers will hold a mix of investments which reflects their views relative to their respective benchmarks or return targets. Within each major market each manager will maintain a diversified portfolio of stocks. May 2018 003
The manager of the passive funds in which the Scheme invests holds a mix of investments within each pooled fund that reflects the composition of their respective benchmark indices. Risk The Scheme is exposed to a number of risks which pose a threat to the Scheme meeting its objectives. The principal risks affecting the Scheme are: Funding risks Financial mismatch The risk that Scheme assets fail to grow in line with the cost of meeting the liabilities. Changing demographics The risk that longevity improves and other demographic factors change, increasing the cost of the Scheme benefits. Systemic risk The possibility of an interlinked and simultaneous failure of several asset classes and/or investment managers, possibly compounded by financial contagion, resulting in an increase in the cost of meeting the Scheme s liabilities. The Trustee manages financial mismatch in a number of ways. Firstly, the Scheme has an explicit allocation to LDI designed to match a proportion of the change in the value of the Scheme s liabilities due to changes in interest rates and inflation. Secondly, the Trustee has set a strategic asset allocation benchmark for the Scheme which takes account of the risk relative to the liabilities. Thirdly, the Trustee assesses risk relative to the strategic benchmark by monitoring the Scheme s asset allocation and investment returns relative to benchmark. The Trustee keeps mortality and other demographic assumptions, which could influence the cost of benefits, under review. These assumptions are considered formally at triennial valuations. The Trustee seeks to mitigate systemic risk through a diversified portfolio but it is not possible to make specific provision for all possible eventualities that may arise under this heading. Asset risks Concentration The risk that a significant allocation to any single asset category and its underperformance relative to expectation would result in difficulties in achieving funding objectives. Illiquidity The risk that the Scheme cannot meet its immediate liabilities because it has insufficient liquid assets. Currency risk The risk that the currency of the Scheme s assets underperforms relative to Sterling (i.e. the currency of the liabilities). The Trustee has partially hedged currency risk in respect of its overseas equity holding (excluding emerging markets). Manager underperformance The failure by the fund managers to achieve the rate of investment return assumed in setting their mandates. Leverage The risk that utilising leverage may result in mark-to-market losses that exceed the amount of capital invested. This is more pertinent for the LDI portfolio which uses a degree of leverage to achieve its objectives in terms of aiming to match changes in the Scheme s liabilities due to movements in interest rates and inflation (up to an agreed level). The leverage of the portfolio was around 2.0x (i.e. the ratio of hedging exposure to the amount of collateral held in the QIAIF) as at end January 2018. The aim is to gradually increase the hedge to 100% of assets, with a 40% total allocation to LDI. This would then mean that the maximum leverage of the portfolio would be around 2.5x once the target hedge is reached. May 2018 004
The Trustee manages asset risks as follows. The Trustee provides a practical constraint on Scheme investments deviating greatly from the intended approach by investing in a range of investment mandates each of which has a defined objective, performance benchmark and manager process which, taken in aggregate, constrain risk within their expected parameters. The LDI portfolio is managed within a QIAIF vehicle which affords a relatively higher level of leverage compared to the previous arrangement. The leverage is kept under regular review by the Trustee, within the context of the objectives of the LDI programme. The Trustee also has an expectation that the LDI manager will have robust processes in place to monitor and manage collateral adequacy to support underlying derivative positions as part of the ongoing management of the portfolio within the QIAIF. By investing across a range of assets, including quoted equities and bonds, the Trustee recognises the need for access to liquidity in the short term. The risk of manager underperformance is mitigated to some extent by the inclusion of passive investment mandates within the investment portfolio. In appointing several investment managers, the Trustee has considered the risk of underperformance by any single investment manager. Other provider risk Transition risk The risk of incurring unexpected costs in relation to the transition of assets among managers. Custody risk The risk of losing economic rights to Scheme assets, when held in custody or when being traded. Credit default The possibility of default of a counterparty in meeting its obligations. The Trustee monitors and manages risks in these areas through a process of regular scrutiny of its providers, and audit of the operations conducted for the Scheme, in addition to the monitoring and management of risk delegated to the appointed investment managers. Expected return on investments The long-term investment objective implies a required rate of return which will be borne in mind when considering changes in strategy. Realisation of investments The majority of the Scheme s investments may be realised quickly if required, with the exception of property and diversified credit funds which may be difficult to realise quickly in certain circumstances. Social, Environmental and Ethical Considerations The Trustee believes that social, environmental and ethical considerations are among the factors which active investment managers should take into account, where relevant, when selecting investments. The Trustee expects that the extent to which these considerations may have a fundamental impact on the portfolio will be taken into account by the investment managers as part of their delegated duties. The Trustee's policy is to consider the managers' policy as part of the manager selection process, and then to leave implementation to their discretion. Exercise of voting rights The Trustee s policy is to delegate responsibility for the exercising of voting rights to the investment managers on the basis that voting power will be exercised by them with the objective of preserving and enhancing long term shareholder value. The Trustee requires its investment managers to comply or explain their position in relation to the Corporate Governance Code. The investment managers are encouraged to address any areas of weakness or non-compliance. May 2018 005
Signed for and on behalf of the Hermes Pension Trustees Limited. May 2018 006
Appendix The table below shows the funds that the Scheme is currently invested in: Manager Legal & General Investment Management Limited ( LGIM ) Insight Investment Funds Management Limited ( Insight ) M&G Investment Management Limited ( M&G ) Barings Investment Funds plc ( Barings ) Hermes Investment Management Limited ( Hermes ) Standard Life Investments Limited ( Standard Life ) Fund World Developed Equity Index Fund World Developed Equity Index Fund GBP Hedged FTSE-RAFI All World 3000 Equity Index Fund FTSE-RAFI All World 3000 Equity Index Fund GBP Hedged Bespoke Hedging Portfolio (within QIAIF) Insight Broad Opportunities Fund M&G Illiquid Credit Opportunities Fund Barings Global High Yield Credit Strategies Fund Hermes Global Emerging Markets Fund Hermes Property Unit Trust Standard Life Long Lease Property Fund *Annual management charges are available on request. May 2018 007