BELIEF INTERPRETATION IMPLICATIONS FOR DECISION MAKING

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1 SKILLS AND COMPETENCIES Investment Belief 1 The Investment Committee should have access to appropriate skills sets. Voting members of the Committee, the Executive Team and investment advisers, and representatives of the Company should have the expertise to manage complex investments. The Investment Committee and supporting personnel currently have the skills to manage complex investment arrangements. If this changed, a review of investment decision-making should be considered. Delegation to third parties not required with current personnel. Resourcing of Executive Team is under regular review. If the composition of the Trustee Board / committee were to change, the Bank would support the Scheme through appointment of Employer Nominated Trustee Directors with appropriate skills. TIME HORIZON Investment Belief 2 There are advantages in taking long term investment positions from time to time. Investments should be managed to a time horizon consistent with the Scheme liabilities. a) In some areas of investment, an illiquidity premium is available for investors with a long term stance. a) As the Scheme has limited need for short term liquidity, a meaningful portion of the assets could be aimed at capturing some illiquidity premium (see footnote on page 10), in some parts of the credit markets or private equity, for example. HBOS Final Salary Pension Scheme 1

2 b) As the Scheme is likely to be invested over several market cycles, this could increase the tolerance for investment in assets with a cyclical pattern of returns. b) Strategic allocations to asset classes with a known cyclicality could be considered. [See market timing below] c) Willingness to use investments with long (10 years +) life d) Preparedness to downplay short-term volatility in exchange for long-term return c) Focus on an appropriate level of return consistent with the risk profile. d) Investments managed to the Trustee's objective of achieving self sufficiency within a strategic time horizon (currently 2034). MARKET TIMING Investment Belief 3 The IC is not in the business of making tactical investment decisions although appropriateness of entry / exit point into an asset class is worthy of consideration Market cycles do create opportunities from timing but it would not be appropriate to rely on market timing in planning the management of pensions investments, and that the role of the Trustee was to manage downside risks. The Committee noted that in practical terms the timing of investment decisions could be delegated to market professionals as part of their mandates. a) Market timing should be considered when structuring new investment mandates b) Implementation of strategic changes should be on a logical/structured basis (as per the current switch from equity to credit). c) Implementation of LDI hedge HBOS Final Salary Pension Scheme 2

3 INVESTMENT MANAGEMENT STYLE Investment Belief 4 In certain markets and circumstances active management, on an unconstrained rather than index-constrained basis, may be appropriate. Markets vary in their efficiency and therefore in their potential for gains from active management. Active management should be used selectively, in markets where the IC has high conviction that value can be added (net of fees), and that a process is in place to identify these skilful managers successfully. A meaningful proportion of the Scheme s assets that are invested in efficient markets might be expected to be managed on an index-tracking basis (see comments on benchmarks below). HBOS Final Salary Pension Scheme 3

4 INVESTMENT STRATEGY AND PENSION LIABILITIES Investment Belief 5 Management of funding level risk as well as asset risks should influence investment strategy. The Investment Committee and Trustee is only interested in asset returns in as much as they affect the development of the Scheme s funding level. Increasing the certainty of achieving long term funding goals is the primary objective of the asset strategy. Changes to asset allocation should be considered in the light of this objective. Performance to be analysed in terms of contribution to meeting this objective over the long-term. DIVERSIFICATION Investment Belief 6 Appropriate diversification within and across asset classes can reduce portfolio risk. a) Diversification across asset classes is expected to have a moderating effect on overall portfolio volatility. a) Diversification across return drivers and risk factors (e.g. equity risk, credit risk, illiquidity risk etc) may be more effective than across asset classes (as asset classes may have large overlaps in risk factors). HBOS Final Salary Pension Scheme 4

5 b) Some diversification of manager risk is prudent. b) Overexposure to a single asset manager brings manager-specific and operational risks. c) In some asset classes, blending managers with complementary investment styles and approaches can have merit. c) Need to consider the resources and time of the Investment Committee and Executive Team in undertaking sufficient monitoring and due diligence, i.e. there is a practical limit on how much diversification can be achieved, based on the governance budget. RISKS AND RISK MANAGEMENT Investment Belief 7 Our risk appetite is driven by our ability to pay pensions as and when they fall due. Risk appetite driven by long term funding objectives and tolerance for short term volatility. Formally setting a risk budget is an explicit way of defining risk appetite. Unrewarded risks to be eliminated if possible (e.g. currency hedging). Rewarded risks to be calibrated as part of asset allocation strategy. Risks other than those captured by funding level volatility (such as longevity or covenant risk) also need to be addressed. HBOS Final Salary Pension Scheme 5

6 COSTS AND FEES Investment Belief 8 We should minimise costs for the value provided, and consider returns net of fees. Genuine manager skill is scarce and is worth paying for. Fees will, if possible, be structured to achieve an effective alignment of manager s and investor s interests. Active management fees should not be paid for beta exposures and managers taking additional risk (e.g. leverage) to generate returns. Beta exposure can often be accessed in cheap, index-tracking form. Flat fees preferred to performance-related fees. Periodic reviews of fees/costs in terms of share of added value accruing to managers may be appropriate. Managers will not be selected solely on the basis of fees: an offer to reduce fees will not mean that an inferior manager will be retained HBOS Final Salary Pension Scheme 6

7 BENCHMARKS Investment Belief 9 We believe in benchmarks. Benchmarks should be appropriate to the investment objectives. a) At the Scheme level, the appropriate benchmark is related to the Trustee's objective of achieving self sufficiency within a strategic time horizon (currently 2034). b) At the manager level, benchmarks should be the return on the asset class in which the manager is invested. c) Traditional or conventional benchmarks may be imperfect or sub-optimal. a) Over longer periods of time, progress along the flight path to meeting funding objectives is the appropriate benchmark for the total Scheme. Contributions to this performance from strategy, structure, managers and liability hedging can be reviewed separately. b) Managers should be given benchmarks which enable both the identification of skill as well as return attributable to beta capture or increased risk. c) Market capitalisation-weighted index benchmarks may be appropriate for measurement of manager performance (as they represent the manager s opportunity set) but may be inferior in other ways, especially if index-tracking management is to be used. Note: In selecting benchmarks, investment managers have a conflict of interest. HBOS Final Salary Pension Scheme 7

8 HISTORY Investment Belief 10 We believe in learning appropriate lessons from the past. History rarely repeats itself in the same form but useful lessons can be learnt from past experience. The Committee could usefully address the question Is it different this time? on an occasional basis. Stress tests can use historic scenarios to understand what ifs derived from the past. Limited reliance should be placed on historic performance track records of asset classes or managers especially if they are short term or the manager has experienced instability. HBOS Final Salary Pension Scheme 8

9 BEHAVIOUR OF INVESTORS Investment Belief 11 We believe that behavioural issues are relevant and are one of the factors to be taken account of in investment decisions. a) The behavioural bias of investors can create market inefficiencies. b) The Investment Committee (and supporting personnel) may have behaviour biases which affects decision-making. a) Active management or restructuring of benchmarks may be able to capture the market inefficiencies created by behavioural biases e.g. low volatility equities. b) Biases in decision-making should be recognised and acknowledged and managed in the operation of the Investment Committee. RESPONSIBLE INVESTMENT Investment Belief 12 We believe in responsible investment. For some asset classes, the Committee believes it is appropriate that managers should invest responsibly, to mitigate against downside risks. Longer term, there is a case for considering more explicit sustainable investment approaches, either by asset type or manager. Scheme to adopt UK stewardship code statement or the overseas equivalent where possible. HBOS Final Salary Pension Scheme 9

10 INVESTMENT ADVICE Investment Belief 13 We believe it is correct to seek best in class advice for each asset class. Investment Belief 14 We believe that the security of investments is paramount No-one has a monopoly of wisdom. a) Effective custody arrangements are key. b) The Investment Committee believes an effective compliance regime must be in place Investment advisers are mandated to provide independent and impartial advice to the Investment Committee (and Trustee) and selection of advisers is considered on a project basis. Managers are neither independent nor regulated to provide investment advice. a) The Executive Team and the Committee will set aside time and resource for monitoring the custodian b) Ongoing compliance reviews for investment managers will continue HBOS Final Salary Pension Scheme 10