JPMorgan Liability-Driven Investment (LDI) Survey · Contents 1 Executive summaries –...

JPMorgan Liability-Driven Investment (LDI) SurveyA survey into trends in risk management among Europe’s Defined Benefit Pension Schemes

Better insight + Better process = Better results

Foreword

Over the last three years, the challenge of bringing pension scheme assets more closely in nature toscheme liabilities has rapidly become the foremost topic of concern across Europe’s pension industry.

But while concern over the need to meet liabilities may be widespread – to what extent are Europe’spension schemes actually taking action and adopting a liability-driven investment (LDI) framework?

In this piece of research, we have sought to gauge both the level of need and the level of demandfor liability-driven investment solutions across Europe’s key pension markets – looking primarily atthe UK, the Netherlands, Sweden and Denmark.

We have looked to see to what extent the concept of LDI is determining how pension schemesmanage their assets and how they define risk. We have also assessed what pension schemes expectto achieve from an LDI strategy and what they are willing to do to achieve those goals – forexample, in terms of using leverage and derivative instruments.

Regional and pan-European trendsThrough this in-depth research we have been able to build up not only an overview of what ishappening across Europe generally but also the specific factors and attitudes within eachindividual market. You can see summaries of our findings for individual markets on pages 3 & 4 of this report.

We have also used our findings to determine the characteristics of the type of pension schemesthat is most likely to support the concept of LDI. These characteristics are summarised at the endof each section. They are also brought together to present an overall picture of the ‘pro-LDIpension scheme’ on pages 1 & 2.

But this exercise to build up a picture of the typical pro-LDI pension scheme can only go so far: ifour research shows anything, it is that perception, drivers and adoption of LDI vary widely acrossEurope. Anyone wishing to be involved in the European LDI market needs to be fully aware of theregional nuances that exist. We hope this survey goes some way to shedding light on both thesimilarities and variations in approach to LDI across Europe.

We would like to thank all the pension schemes that generously gave their time to take part in thissurvey. Europe’s pension sector faces some fascinating challenges – thanks to the participants inthis survey, we have been able to provide an invaluable overview of the attitudes and concernsthat are likely to shape the industry over the next five years.

Karin FranceriesHead of Client Solutions Group, EuropeJPMorgan Asset ManagementJune 2006

JPMorgan Liability-Driven Investment (LDI) Survey

Contents1 Executive summaries

– Characteristics of schemes interested in adopting LDI

– Regional summaries of key findings

5 Conducting the Survey

Findings

7 Part One – Pension arrangements

11 Part Two – Managing scheme assets

17 Part Three – Managing liabilities

23 Part Four – Using derivatives in an investment strategy

27 Part Five – Defining and measuring risk

31 Part Six – Attitudes to liability-driven investment

39 Conclusion

Appendix

41 The regulatory landscape – a brief overview

42 Glossary of terms

LDI solutions at JPMorgan Asset Management

JPMorgan has over 25 years’ experience of asset-liability management for pension schemes.

In 2005, we formed the Client Solutions Team to provide dedicated liability-driven investment (LDI) solutionsfor pension schemes looking for a risk framework in which to manage assets against their liabilities.

Working closely with JPMAM Global Fixed Income and Global Multi-Asset Groups, the Client Solutions Teamis able to structure a range of LDI solutions that both look to hedge liability risk and generate alpha to addressfunding deficits.

By choosing JPMorgan Asset Management as a provider of LDI solutions, pension schemes can enjoy the following advantages

Extensive fixed income expertise to meet both nominal and inflation-linked liabilities

Strong derivatives capability to structure swaps, forwards and other contracts on competitive pricing terms

Over 160 sources of alpha from the full range of traditional and alternative asset classes

Extensive experience in tactical asset allocation and portable alpha techniques

Talk to us

To discuss your scheme’s LDI requirements, speak to your local JPMAM representative

Characteristics of pension schemes interested in adopting LDI 1

At the end of each section of this survey, we have summarised the characteristics of pensionschemes that support the concept of LDI. This has been done by cross-referencing each section’sfindings with the percentage of respondents that say they are considering, implementing or usingan LDI strategy (See Part 6 – Attitudes to liability-driven investment, page 31).

Key characteristics: nationality, size and funding levelLDI adopters represent 47% of the survey’s respondents

They usually belong to countries where the regulations push pension schemes to valuetheir liabilities using market rates, such as the Netherlands (66%), Denmark or Sweden (53%)or the UK (44%). Throughout the rest of Europe, they only represent 30% of respondents

They are of a bigger size (their pension liabilities are higher than the LDI sceptics by 61%)

In the UK 86% of LDI adopters are likely to have a contained deficit representing less than 25%of their liabilities, whilst LDI sceptics have a scattered funding status

In the Netherlands, Sweden and Denmark, the funding status is not a differentiating factor

In the UK, one out of two pension schemes interested in LDI have closed their defined benefit(DB) scheme to new members

Impact of ‘external’ parties: the regulator is key, the plan sponsor is not instrumentalPro-LDI respondents have experienced more regulatoy pressure than LDI sceptics: in theNetherlands, Denmark and Sweden, more than 67% pro-LDI schemes had experienced pressurefrom the regulator compared to 36% at most for the LDI sceptics

In the UK, more pro LDIs had experienced pressure from the regulator than LDI sceptics but in majority, the schemes, whether for or against LDI, claimed to have received no pressure from the regulator

Across Europe, pension schemes that are looking to implement LDI strategies feel they havemore influence over contribution levels than schemes that do not support LDI

A minority of schemes are using the plan sponsor’s expertise to implement LDI strategies

Implementation of LDI is at different stages across Europe Amongst pro LDIs, 60% have not yet completed the implementation of their LDI strategy

This is especially true in the UK, where 70% of the pro LDIs are still at the thinking phase prior to implementation

Of pro-LDI adopters in the Netherlands, Denmark and Sweden, LDI has already beenimplemented or is in the process of being implemented in more than 75% of cases

Executive Summaries

JPMorgan Liability-Driven Investment (LDI) Survey01

1 These may be read in light of the regulatory differences in each market, summarised on page 41

LDI penetration: Today and in the next five years

Denmark, Sweden and the Netherlands predict the highest take-up of LDI in their respectivemarkets over the next five years

LDI has started with a reshuffling of the fixed income portfolio Pro-LDI respondents tend to have a higher fixed income allocation and notably in the UK,a lower equity allocation

In the Netherlands, pro-LDI schemes have a marginally lower fixed income allocation but morediversification in alternative assets

Pro-LDI schemes are more likely to have increased their fixed income duration

Pro-LDI respondents are far more inclined to use derivative instruments such as swaps thanpension schemes that have no interest in LDI. For example, in the UK only 21% of pro-LDIschemes would not consider using swaps compared to 70% of LDI sceptics

Management of liabilities: paradoxically, not a strong differentiating factor Pro-LDI respondents prefer an ‘economic’ valuation of their liabilities based on the yield curve

Pro-LDI pension schemes are marginally more likely to define risk in terms of liabilities (eg the funding status deteriorating or the need for unplanned sponsor contributions) ratherthan in terms of asset performance

However, with regards to the other liability parameters analysed here, the pro-LDI respondentsare surprisingly very similar to the LDI sceptics:

– They value their liabilities with the same frequency as schemes that are not interested in LDI

– They have a similar duration of liabilities

– They have a similar time horizon for closing deficits


Current LDI Users

Pro-LDIs*

Respondents assumption of LDI penetration**

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%13%

44%

31%

66%

53%

30%

3%

33%

0%

75 to 100%

UK NLDK/S

E

Rest of

Europe

*Respondents that are using an LDI strategy, in the process of implementing or thinking about implementing one.**Highest occurrence of market penetration scale as estimated by pro LDI respondents. In the UK, represented 54% of ‘pro-LDI’, in the Netherlands 45%, in Denmark/

that between 25%-50% of pension funds would adopt LDI in the next five years.Sweden 71% and in the rest of Europe 50%. For example 54% of the UK pro-LDIs thought

25 to 50%

75 to 100%

0 to 25%

Regional summaries of key findings 1

The UKFunding status – 74% of UK respondents reported a scheme deficit, representing the countrywith the highest incidence of schemes with a deficit in Europe.

Fixed income duration – UK schemes have the longest duration in their portfolios – currentlyrunning at just over 15 years. Almost two-thirds have made no changes to their duration in the last two years and have no plans to change it – the highest percentage in Europe.

Derivatives – UK schemes showed the strongest resistance to using derivative instrumentswithin their investment strategy and primarily use them for currency risk hedging. However,they appeared marginally the most keen to use leverage in an LDI strategy to help reduce adeficit – with 27% believing leverage should be included in an LDI strategy.

Regulations – One in three UK schemes would still prefer to value the current value of theirliabilities using a discount rate based on the expected return of assets rather than on marketinterest rates. Four out of 10 schemes said that they would take more than 10 years to close adeficit, conflicting with regulatory requirements.

Risk management – The majority of UK schemes (80%) measure risk in terms of performancerelative to a market benchmark – but almost two out of three also measure risk in terms of thescheme’s funding status.

Adoption of LDI – 13% of UK respondents already have an LDI strategy in place, with a further28% currently considering implementing an LDI Strategy. This is in line with respondents’views on the UK market’s level of adoption of LDI at 25%-50% of UK schemes by 2011.

The NetherlandsFunding status – 96% of Dutch respondents reported a surplus – the highest percentageacross Europe.

Fixed income duration – Currently, Dutch pension portfolios have the second-longest durationat 10.5 years. This is set to lengthen to 13.8 years on average, as over half have increased or areabout to change their duration. In most cases this is for liability-driven reasons.

Derivatives – More than half of Dutch pension schemes are using or planning to usederivatives. The Netherlands also recorded the highest percentage of respondents (26%) usingderivatives expressly for liability-matching purposes.

Regulations – The majority of Dutch schemes believe that the regulatory regime they workunder-requiring liabilities to be valued using a stream of discount rates aligned to the yieldcurve-is the most meaningful method to value pension obligations.

Risk management – The Netherlands recorded the highest percentage of respondents (35%)that defined risk in terms of the deterioration of a scheme’s funding status. In addition, asignificant 22% of Dutch schemes viewed LDI primarily in terms of managing deficits ratherthan matching liability cashflows.


1 These may be read in light of the regulatory differences in each market, summarised on page 41

Denmark & Sweden (DK/SE)Funding status – Almost all (92%) respondents in DK and SE have a surplus.

Fixed income duration – Respondents in this region have one of the shortest fixed incomedurations at just 6.2 years. But this region also has the highest incidence of pension schemesaltering their duration, with the average duration set to lengthen to 7.8 years.

Derivatives – Pension schemes in DK/SE were by far the highest users of derivatives in oursurvey. Danish schemes recorded the highest use of swaps and swaptions, while Swedishschemes were the biggest users of options, futures and forwards. Like other regions, derivativesare most commonly used for currency hedging but around one in four schemes are using themfor liability-matching purposes and one in five to manage equity risk.

Risk management – Absolute rather than relative investment performance appears mostimportant in this region. More than three-quarters of schemes (78%) quantify the risk offailing to meet a target absolute return – the highest in Europe. Only 56% of schemes in thisregion quantify the risk of underperformance relative to a market benchmark.

Adoption of LDI – Denmark and Sweden have the highest percentage (33%) of schemes thatalready have an LDI scheme in place – with a further 20% implementing or consideringimplementing an LDI strategy. They are also the most bullish about the uptake of LDI, with71% of respondents believing LDI will be adopted by three-quarters or more of pensionschemes in their region by 2011.


Who and when we surveyedThe targeted survey group comprised corporates, local authority pension schemes, industry-basedschemes and plans regulated as insurance companies. The survey was conducted during December 2005-March 2006, with responses provided as hard-copy, by telephone interview or on online.

In total we received completed responses from 214 defined benefit pension schemes across 14 European countries. This group represents total pension assets of almost €750 billion(£500bn/US$870bn).

Key markets focused on:We have focused primarily on the findings of those markets where we saw the strongest responseto our survey – namely the UK, Netherlands, Denmark and Sweden. The percentage of totalnational pension assets represented by our respondent sample in these four markets is significant:

For most responses, Denmark and Sweden have been grouped together because their regulatoryenvironment is very similar. However, where responses from Denmark and Sweden have divergedsignificantly, we have separated out the two countries. We saw a substantially lower response ratefrom pension schemes in the rest of Europe – perhaps reflecting the fact that the concept of LDI is less recognised because funding requirements are not based on the market value of liabilities.Respondents from countries outside of the UK, Netherlands, Denmark and Sweden have thereforebeen grouped together as ‘Rest of Europe’. For an overview of the regulatory variations andsimilarities across Europe, see the appendix, page 41.

Size of pension schemes surveyedWe attracted responses from a wide range of different sizes of pension scheme. The breakdown ofrespondents by their size of assets under management is as follows:

Just over three out of four (77%) of pension schemes surveyed have a corporate sponsor.


Country group % of our total survey group % of national pension market 1

UK 43% 16%

Netherlands 19% 16%

Denmark 7% 34%

Sweden 11% 25%

Rest of Europe2 20% not meaningful

1 Based on total value of national pension assets – source: JPMAM, Dutch Central Bureau of Statistics

2 The Rest of Europe group consists of pension schemes located in Switzerland (which represents 6% of the overall number of respondents), Germany(5%), Norway (4%), Finland (1%), as well as Austria, France, Belgium, Ireland, Portugal and Spain (which collectively represents 4%)

Assets Rest of % of (market value) UK Netherlands DK&SE Europe respondents

Less than €750m (£510m) 20% 50% 33% 47% 33%

€750m-€1.5bn (£510m-£1.02bn) 25% 16% 11% 3% 17%

€1.5bn-€3.0bn (£1.02bn-£2.05bn) 29% 19% 19% 23% 24%

€3.0bn-€7.0bn (£3.05bn-£4.8bn) 19% 3% 22% 7% 14%

More than €7.0bn (£4.8bn) 7% 12% 15% 20% 12%

Conducting the survey


Part One:Pension arrangements

OverviewThe closure of defined benefit (DB) pension schemes in favour of definedcontribution (DC) schemes is a well-established trend in the UK but onlymarginal in other countries. The trend for DB scheme closure is particularlystrong among smaller UK schemes

Forty percent of European schemes surveyed are in deficit. The UK recordingthe highest incidence of deficit at around three-quarters of all schemes surveyed

Almost all pension schemes with a corporate sponsor believe the sponsor hasgreater awareness of its pension exposure than 5 years ago. One in threeschemes in Europe attributes this to new accounting requirements


Type of pension scheme offeredLiability-driven investing is most relevant to DB pension schemes and DC schemes with aguaranteed element as the pension scheme (and indirectly its sponsor) is bearing some or all ofthe risk of funding the pension promise. LDI is not an issue for pure ‘defined contribution’schemes where the funding risk is fully borne by the plan member.

We therefore asked our respondents which of these three types of pension scheme they offer. Theirresponses are driven in part by regulatory requirements, which can be summarised as follows:

In Denmark and Switzerland, DC schemes with a minimum guaranteed return are preferred asa means of ‘Pillar 2’ (i.e. employer) pension provision

In the Netherlands, regulation favours DB provision

In the UK, there is no regulatory requirement determining whether DB or DC schemes are offered

Availability of different schemesWe also looked to see to what extent schemes are open or closed to employees. Overall, DBschemes were marginally the most prevalent form of open pension arrangement among oursurvey group – with two-thirds of respondent schemes offering them to all employees. DBschemes are most accessible in the Netherlands, being open to all employees in 93% of cases.

On average across Europe, one in four DB schemes offered by our respondents is closed to newmembers. This trend is most advanced in the UK, with 38% of DB schemes closed to newmembers. In fact, in the UK, it was most noticeable that of those schemes that offer both a DB anda DC scheme, the majority have now closed their DB scheme to new members.

In other countries, the two types of plan tend to co-exist rather than one replacing the other. Forexample, only 7% of DB schemes are closed to new members in the Netherlands and only 13% inDenmark/Sweden. (In Sweden, the limited availability of DB may be due to the different pensionentitlements of blue-collar and white-collar workers).

Please note: schemes that only offer DC pension provision were not invited to provide responsesto the rest of our survey.

Scheme availability by size of assetsWhen assessed by size of assets under management, it was clear that the smaller a pension fund is,the more likely it is that it will have closed its DB offering and/or offer a DC-based plan. Again,this trend was particularly marked in the UK.

Type of pension Defined Benefit Defined Contribution Defined Contributionscheme offered (DB) (DC) with Capital Guarantee

UK 100% 71% 6%

NL 100% 78% 0%

DK 50% 80% 88%

SE 90% 78% 44%

Rest of Europe 93% 75% 72%

Overall 97% 74% 40%

JPMorgan Liability-Driven Investment (LDI) Survey

Size of deficitOverall, 40% of the pension schemes surveyed reported a deficit in their liabilities, based on a marketvalue of liabilities. The UK reported the highest percentage, with 74% of schemes in deficit. On average,this deficit represented 5% of the liabilities. By contrast, schemes in other regions had a sizeablesurplus, which represented 11% of the liabilities in the Netherlands and 8% in Denmark/Sweden.

In those markets where funding regulations are more stringent – such as the Netherlands, Denmarkand Sweden – very few schemes reported a deficit.

Awareness of pension exposure by sponsor/company The vast majority of respondents that have a plan sponsor indicated that the sponsor has a greaterawareness of its pension exposure than it did five years ago:

The key reasons for this greater awareness varied. In the UK, the growth in pension deficits wasgiven as the principal reason for sponsors taking greater interest in their pension exposure (notsurprising given that UK schemes had the highest incidence and level of deficit). Changes incompany accounting were also a key influence in the UK.

In the Netherlands where only 4% of schemes are in deficit, the change in accounting standards,i.e. the introduction of nFTK in 2007, was by far the biggest reason for sponsors having greaterawareness of pension risk.

Pension schemes in Denmark and Sweden reported far less pressure from accounting changes.Instead respondent schemes in those countries and the rest of Europe felt that scrutiny from thefinancial community (i.e. credit rating agencies, market analysts, share and bondholders) wasdriving greater focus on sponsors’ pension exposure.

These findings are perhaps surprising for Denmark and Sweden – as the stringent fundingrequirements introduced in 2001 and 2006 respectively might have been expected to be themain focus of interest for sponsors. The fact that pension schemes in those regions reporthigh interest from the financial community may reflect that the financial community wassupportive of the changes.

Deficit band (as a % UK NL DK/SE Rest of Overallof pension liabilities)* Europe

Surplus 26% 96% 92% 72% 60%

Deficit of 0-25% 60% 4% 4% 17% 31%

Deficit of 25-50% 14% 0% 4% 11% 9%

*based on market value of liabilities

Factors driving sponsor UK NL DK/SE Rest of Overallinterest in pension exposure Europe

Accounting changes 31% 55% 18% 23% 32%

Requirement from the regulator 3% 3% 9% 3% 4%to increase contributions

Increasing awareness of the 17% 14% 41% 45% 26%financial community

Deficit increase 43% 0% 5% 16% 24%

Other (please specify) 6% 28% 27% 13% 14%

Sponsor’s awareness UK NL UK UK UKof pension exposure

Greater awareness than 5 years ago 96% 100% 96% 91% 96%

No greater awareness 4% 0% 4% 9% 4%

08

Comment

Characteristics of schemes interested in LDI*

1. Size of schemeThose schemes that are considering, implementing or using an LDI strategy are on average slightly larger than those schemes that are not interested in LDI:

In the UK, pro-LDI respondents have on average 20% more liabilities

In the Netherlands, pro-LDI respondents have on average 31% more liabilities

On average in Europe, pro-LDI respondents have 61% more liabilities

Therefore size of liabilities could be a catalyst for interest in LDI.

2. Size of deficitThose schemes that are interested in implementing LDI have on average a smaller deficit thanthose that are not interested in LDI. This is notably the case in the UK and Rest of Europewhereas the funding status is quite similar for the Netherlands, Denmark or Sweden whetherpension schemes are for or against LDI. Indeed, in those regions, the funding ratios are verystrict (see regulation summary page 41).

In the UK, where the minimum funding requirements are more flexible, the schemes who have a strong deficit (above 25% of the liabilities) are not likely to implement LDI strategies.

It may be that these schemes believe they should take risk in the short term to make up for theirdeficit in the long term. Hence they may believe they do not have sufficient funds to afford anLDI strategy.

3. Schemes offered In the UK, those pension schemes that are interested in LDI are more likely to have closed theirdefined benefit schemes than those who are against LDI:

52% of UK pro-LDI plans have closed their DB schemes

Only 26% of LDI sceptics in the UK have closed their DB schemes

*Based on a cross-reference of respondents who are considering, implementing or using an LDI strategy –

see Part 6 – Attitudes to Liability-Driven Investment.

Deficit band UK NL DK/SE Rest of OverallEurope

Surplus 10% 95% 100% 50% 62%

0 – 25% 86% 5% 0% 17% 33%

25 – 50% 5% 0% 0% 33% 5%

Pro-LDI respondents

LDI Sceptics


Deficit band UK NL DK/SE Rest of OverallEurope

Surplus 35% 100% 78% 82% 57%

0 – 25% 44% 0% 11% 0% 30%

25 – 50% 21% 0% 11% 18% 13%

OverviewMost schemes continue to hold the majority of their assets in fixed income;the UK is the only market where average equity exposure exceeds 50%

One in two pension schemes are looking to alter their fixed-income duration;57% of these are looking to change for liability-driven reasons

If pension schemes make their intended duration changes, the average fixedduration will rise from 9.3 to 11.1 years

UK schemes anticipate taking the longest to close a deficit: over 40% of UKschemes estimate taking more than 10 years to eradicate a deficit

Part Two:Managing pension scheme assets

Asset allocationAs expected, the allocation of pension scheme assets varies significantly across Europe. UKschemes retain the highest average equity exposure at 59.2% compared to 39.9% for Europe as awhole. However, this might still be considered low for the UK, where equity exposure has beencloser to 70% historically.

Pension schemes in Denmark and Sweden have the highest exposure to bonds at 57%, although‘Rest of Europe’ is not far behind with average bond exposure of 52.5%.

Across the whole of Europe, pension scheme exposure to ‘alternative’ asset classes such as realestate, private equity and hedge funds remains low. Pension schemes in the Netherlands retainalmost twice the exposure to real estate as their counterparts in the UK, Denmark and Sweden. In‘Rest of Europe’ we also saw relatively high real estate exposure from respondents in Switzerland.

The high incidence of deficit among UK pension schemes could be partly attributable to theirhigher exposure to equities, which would have had a negative impact during the last bearmarket and introduces a stronger-than-average volatility of their funding status.

On the other hand, as we will see on the following pages, the fixed income duration of UKpension schemes tends to be significantly higher than in other countries – which shouldhave a mitigating effect on their funding status volatility.

Equity exposure in the Netherlands, Sweden and Denmark appears low compared to the UKbecause it has historically been limited to fixed percentages.

These fixed limits are now being replaced by stress testing, which give schemes more flexibilityin their asset allocation. However, the more risk a scheme takes with its asset allocation, themore surplus it will require to withstand the stress-testing requirements. It will be interestingto see whether or not schemes that are heavily in surplus take advantage of these new rulesto increase their equity exposure.

Exposure to asset classes other than bonds and equities is uniformly low across Europe. Thisis interesting given that, as we see in Part Three – Managing liabilities, a high percentage ofschemes claimed to have increased their exposure to alternative assets in response to theirlatest Asset-Liability Modelling analysis.

Pension schemeasset allocation

Equities

Bonds

Real Estate

Private Equity

Hedge Funds

Other

UK

59.2%

32.7%

4.5%

0.7%

0.5%

2.4%

NL

36.9%

49.9%

8.4%

0.9%

0.9%

3.0%

DK/SE

32.6%

57.0%

4.9%

0.8%

1.4%

3.3%

Rest ofEurope

30.8%

52.5%

11.3%

1.1%

1.1%

3.2%

Overall

39.9%

48.0%

7.4%

0.8%

1.0%

2.9%


Comment

Changes in fixed income durationOverall, half of the pension schemes we surveyed have either altered or are considering alteringtheir fixed income duration. This trend is most marked in Denmark and Sweden, with 70% ofrespondents making or considering changes.

Conversely, it is noticeable that almost two-thirds of our UK respondents (64%) have no intentionto alter duration, which could be attributable to the fact that UK schemes already have the longestduration among our survey respondents (see table on page 13).

Of those schemes that have made or are considering changes to their fixed income duration, themajority are doing so for ‘liability-driven’ reasons – this is most evident in the UK and theNetherlands. In Sweden, more than 40% of schemes were making a tactical move in the fixedincome markets. Changes in fixed income duration in the ‘Rest of Europe’ were also principallytactical investment decisions rather than liability-driven.

It is curious that a significant proportion of pension schemes are looking to increase fixedincome duration for tactical reasons. This suggests that these respondents expected interestrates to decrease in the short term, which is not the consensus view.

In most cases where pension schemes are looking to make changes, they are looking to extendduration. The key exception is Sweden, where 30% of pension schemes modifying their fixedincome duration have decreased it. On average ‘current’ duration for European pension schemes is 9.3 years. If pension schemes go ahead with their intended changes to duration, this will rise to 11.1 years – as the table overleaf shows.

Changes in fixed UK NL DK/SE Rest of Overallincome duration Europe

Yes – in the last two years 25% 39% 53% 52% 60%

No, but considering it 11% 15% 17% % 31%

No, and not considering it 64% 46% 30% 11% 9%

Changes in fixed UK NL DK/SE Rest of Overallincome duration Europe

Yes – in the last two years 25% 39% 53% 52% 38%

No, but considering it 11% 15% 17% 6% 12%

No, and not considering it 64% 46% 30% 42% 50%


Reason for altering UK NL Denmark Sweden Rest of Overallfixed income duration Europe

Tactical view 26% 14% 33% 43% 78% 38%

Liability driven 70% 76% 67% 50% 22% 57%

Other (see below) 4% 10% 0% 7% 0% 5%

Other reasons given: 1. to increase performance; 2. strategic change; 3. regulatory changes

Comment

18

16

14

12

10

8

6

4

2

0

Year

s

15.1

17.1

10.5

13.8

6.2

7.8

5.86.3

9.3

11.1

UK NLDK/S

E

Rest of

Europe

Whole of

Europe

Average current duration

Average future duration

Current and intended fixed income duration of European pension schemes

Notes to chartAverage current duration – calculated on the current duration of schemes that are considering and not consideringchanges plus the previous duration of schemes that have implemented changes in the last two years.

Average future duration – calculated on the current duration of schemes that have implemented changes in the lasttwo years, the current duration of schemes not considering changes, and the planned duration of those schemes thatare considering changes

We are surprised at how high duration is across our survey group. The fact that pensionschemes are – on average – looking to extend duration to 11 years suggests that they are farmore aware of their risks. It may also indicate that schemes are taking advantage of newissues of government long-duration bonds.

It is particularly notable that average intended duration among our UK respondents is sixyears higher than the average for our survey group. This is especially intriguing, given thatthe UK yield curve is inverted and there are no specific regulatory requirements for UKpension schemes to hold long-duration investments.

However, this longer duration needs to be assessed against the fact that UK schemes tend to have lower fixed income exposure than their counterparts in other European countries – as we have seen on page 11. Among UK schemes, fixed income exposure is just 32.7%. Soassuming that other asset classes have no duration, then the overall portfolio durationamong UK pension schemes is only around 5 years (marginally higher than the averageportfolio duration for Europe as a whole of 4.5 years).

Although duration of assets is being extended across Europe, it is important to note thatduration of scheme liabilities now stands at around 20 years on average (see ‘Part Three –Managing Liabilities’, page 17). Therefore a significant duration mismatch will still remainbetween assets and liabilities – even after schemes have implemented their current plansto extend their fixed income duration.


Comment


Asset allocation

Pro LDIs tend to have a higher fixed income allocation and, notably in the UK, a lower equity allocation

JPMorgan Liability-Driven Investment (LDI) SurveyJPMorgan Liability-Driven Investment (LDI) Survey14

UK NL DK SE Rest of TotalEurope

Pro-LDI

Equity 48% 34% 26% 36% 35% 39%

Fixed income 42% 46% 66% 56% 48% 48%

Other assets 10% 20% 8% 8% 17% 13%

LDI sceptics

Equity 68% 37% 14% 43% 30% 50%

Fixed income 25% 52% 64% 52% 52% 40%

Other assets 7% 11% 22% 7% 18% 10%

It is interesting to see that the situation is different for the Netherlands as the allocation to fixedincome is actually slightly smaller for the pro-LDI respondents compared to the LDI sceptics,whilst their equity allocation is almost identical. This may suggest that Dutch pro-LDI pensionschemes have significantly reduced their risk budget by increasing the duration of their fixedincome portfolio. They have then been able to reallocate this part of their risk budget todiversified alternative asset classes.

Fixed income duration

Pro-LDI respondents are more likely to have changed their fixed income duration. Overall, 46%of pro-LDI respondents have changed their fixed income portfolio over the last two years(compared to 32% for LDI sceptics). In the Netherlands, Denmark and Sweden, more than 50%have done so, compared to 33% of UK respondents.

When including those pension schemes that are contemplating increasing their duration, we seethat an average of 64% of European pro-LDI respondents are concerned with a durationincrease, compared to 38% of LDI sceptics.

It is worth mentioning that 47% of the UK pro-LDI schemes do not want to increase duration,nor have they done so in the last two years.

*Based on a cross-reference of respondents who are considering, implementing or already using an LDI strategy –


Part Three:Managing liabilities

OverviewThe majority of pension schemes review the current value of their pensionbenefit obligations (PBO), and the assumptions on which they are based atleast every 12 months. UK schemes review their PBO significantly lessfrequently than schemes in other parts of Europe

Most schemes favour valuing liabilities using a discount rate based on theyield curve – except in the UK, where a rate based on the expected or realisedreturn on assets is marginally preferred

The average duration of liabilities among our survey group is 21 years

Over half (58%) of pension schemes in Europe believe asset-liabilitymodelling is already a key factor in their asset allocation. More than one inthree schemes in the Netherlands believes it should be secondary to absoluteperformance of assets

Managing LiabilitiesUnderstanding how liabilities are measured must clearly be a key component of any LDI strategy.We therefore asked pension schemes detailed questions about their valuation methods – primarilyfocusing on two measures:

the pension benefit payment assumptions (e.g. mortality rates, inflation)

the present value of these pension benefit payments – referred to as the ‘pension benefit obligations’ (PBO)

Reviewing pension benefit payment assumptionsOn average, pension schemes in Europe review the assumptions used to calculate their pensionbenefit payments every 20 months.

The vast majority of schemes across continental Europe look to review assumptions at least once a year. Almost half of respondents in Denmark and Sweden claim assumptions are reviewed atleast every three months.

Conversely in the UK, over two-thirds (69%) of pension schemes say they only reviewassumptions every two to three years.

Reviewing the present value of pension benefit paymentsThe present value of pension benefit obligations is reviewed far more frequently – with 46% ofrespondents reviewing it every 3 to 12 months or less, and just over one in three schemesreviewing values at least every three months. The UK is the only region where there is a significantproportion of schemes reviewing the value of obligations less frequently than once a year.

Measuring the current value of liabilitiesWhen measuring the current value of liabilities, the method of valuation that is deemed to bemost meaningful varied from region to region. Moreover, as the table shows below, the methodthat is deemed the most meaningful can diverge from the method of valuation that pensionschemes in each region are required to use.

Pension schemes in the Netherlands, Denmark and Sweden prefer a discount rate aligned to theyield curve, which is basically the method they must use under their funding regulations.

UK schemes are also recommended under the FRS17 accounting standard to use this approach –but only one in four (26%) of UK schemes believe it to be the best method to use. Instead, one inthree UK schemes prefers a discount rate based on the expected or realised return of pensionassets – i.e. the way in which UK pension schemes were valuing liabilities before the introduction of FRS17.

Respondents in the Rest of Europe, where liabilities are generally discounted at a fixed rate, arefairly evenly split between favouring a yield-curve based rate, a fixed rate or a rate based on theperformance of assets.

Frequency of review of pension UK NL DK/SE Rest of Overallbenefit obligations Europe

3 months or less 20% 59% 69% 25% 38%

3 to 12 months 48% 38% 27% 71% 46%

1 to 2 years 0% 3% 0% 4% 1%

2 to 3 years 32% 0% 4% 0% 15%


50%

45%

40%

35%

30%

25%

20%

15%

10%

5%

0%

5%

18%

46%

16%

7% 8%

Less

than 10

yrs

10 – 15 yrs

15 – 20 yrs

20 – 30 yrs

30 – 50 yrs

50 yrs or m

ore


Most meaningful discount rate UK NL DK/SE Rest of OverallEurope

(Shading indicates the method schemes in each region are obliged to use).

A fixed discount rate 12% 6% 3% 26% 12%

A market based rate 26% 76% 70% 32% 45%

The expected or realised assets’ return 36% 12% 17% 26% 26%

Do not know / other 26% 6% 10% 16% 17%

Comment

If we compare the graph above with the graph of fixed income duration on page X, we canclearly see the mismatch between assets and liabilities among Europe’s pension schemes.With the average duration of most liabilities standing at 15 years or more, schemes will haveno choice but to look beyond ‘cash’ fixed income instruments if they wish to achieve a bettermatch between the two.

Comment

UK pension schemes are less equipped than their European peers to review their pensionliabilities on a continuous basis.

They retain a marked preference for calculating liabilities based on the forecast or actualreturn on assets. This could be attributable to the fact that they retain higher exposure toequities, which have the potential to achieve a significantly higher return than the bond yieldthat they are now obliged to use.

In fact, a discount method based on asset return saw reasonably strong support across allmarkets. However this method carries significant risk in that it does not take into account thepotential mismatch between the investment return and the actual cash flow required to paythe pension benefits: but there is no certainty that at a given point in time there will besufficient cash to make benefit payments. It might be true that over the long term a specificasset allocation will generate its long term expected return.

Duration of liabilitiesThe average duration of liabilities of our surveyed pension schemes was 21 years, with the heaviestconcentration in the 15-20 year band:

Average duration of liabilities

Asset Liability Modelling (ALM) analysisOn average the pension schemes in our survey carry out an Asset-Liability Modelling (ALM)analysis every 29 months – with a third of schemes analysing ALM at least once a year.

In every region, more than half of respondents say that ALM is a key determinant of their assetallocation and takes precedence over the absolute performance of assets. However, the Netherlandsstill reported a reasonably high incidence (38%) of respondents who believe that ALM should besecondary to absolute performance of assets.

The fact that more than one in three pension schemes in the Netherlands believe that asset-liability modelling should be secondary to absolute performance of assets may simply reflect the stronger funding status that Dutch pension schemes generally enjoy – a situationthat allows them to focus more on actual investment performance and less on how it relatesto their liabilities.

Responding to asset-liability modellingWhen asked what action they have taken/are considering as a result of their last ALM analysis, onein three pension schemes across Europe say they have increased exposure to alternative investmentstrategies. More than 40% of respondents in the Netherlands have increased their duration, while athird of schemes in the UK have reduced equity exposure.

Frequency of Asset-Liability UK NL DK/SE Rest of OverallModelling analysis Europe

12 months or less 12% 24% 76% 26% 30%

12-24 months 4% 27% 10% 9% 12%

2- 3 years 72% 37% 14% 39% 45%

3 years or more 12% 12% 0% 26% 13%

Perception of UK NL DK/SE Rest of OverallAsset-Liability Modelling Europe

It is a key aspect of current asset allocation 54% 59% 67% 56% 58%

Second to absolute performance of assets 22% 38% 23% 29% 27%

Do not know / not applicable 24% 3% 10% 15% 15%


Comment

In ‘Part Two – Managing pension scheme assets’, we saw that a significant majority ofschemes have increased their fixed income duration in the last two years or plan to do so in the near future (See page 12). However, in the findings above we see that only 17% ofschemes say they have increased or are planning to increase the duration of their portfoliodirectly in response to their last ALM analysis.

We can see two reasons for this:

an ALM analysis might not have been the main driver for duration changePart of the schemes having reduced their equity exposure following their ALM will havedone so in favour of their fixed income portfolio. So the high proportion of ALM reviewsresulting in an equity reduction (22% on average) could translate into higher fixedincome allocation of a longer duration.

It is also interesting to note that in Part Two we saw that allocation to alternative assets suchas real estate, private equity and hedge funds is still extremely low. However, one in threepension schemes claim to be increasing their exposure to alternative investment strategiesspecifically as a result of their last asset-liability modelling exercise.

Influence over pension contributionsMore than three out of four (77%) pension schemes across Europe feel they have moderate orsignificant influence over the level of contributions going into the scheme. Pension schemes inDenmark and Sweden felt they have the lowest level of influence in this respect.

Changes made as a result of UK NL DK/SE Rest of Overallmost recent ALM analysis Europe

Increased duration 7% 41% 17% 7% 17%

Reduced equity exposure 31% 15% 3% 21% 22%

Increased equity exposure 3% 6% 7% 6% 6%

Increased allocation to alternative investment strategies 30% 44% 17% 39% 33%

No action taken 23% 21% 30% 14% 25%

Other 10% 18% 10% 15% 13%


Influence on level of UK NL DK/SE Rest of Overallpension contributions Europe

Significant influence 32% 30% 17% 37% 30%

Moderate influence 51% 47% 48% 37% 47%

No influence 17% 23% 35% 26% 23%


Comment

Addressing deficitsWhen a deficit occurs, the target time horizon for closing it varies substantially between differentregions. In the UK, 74% of schemes say they would take six years or more to close a deficit, withmore than 40% taking more than 11 years. In the Netherlands, only 21% of respondents said theywould take six years or more to close a deficit.

A high percentage of respondents felt the issue of deficit closure was not applicable to themas they are technically not allowed to go into deficit. If they do, the sponsor is obliged to meetthe shortfall. However it is interesting to see in ‘Part Five – Defining and Measuring Risk’ thatfew schemes in this position have yet to regard such unplanned sponsor contributions as asignificant form of risk that needs to be monitored (see page 27).

Four out of ten UK pension schemes say they would take more than 11 years to close adeficit. It is very interesting that this conflicts with UK regulatory requirements, whichrecommends that a deficit should be reduced within 10 years.

Time horizon for closing UK NL Denmark Sweden Rest of Overalla deficit Europe

1 year 2% 24% 11% 11% 10% 9%

2-5 years 14% 15% 11% 21% 20% 16%

6-10 years 33% 6% 0% 0% 7% 17%

11+ years 41% 15% 11% 11% 3% 24%

Do not know / not applicable 10% 40% 67% 57% 60% 34%


Our findings suggest that pro-LDI respondents prefer an ‘economic’ valuation of theirliabilities based on the yield curve (48% across Europe compared to 36% for the LDI sceptics)

In the UK, pension schemes looking to implement LDI strategies feel they have moreinfluence over contribution levels than schemes that do not support LDI: only 7% feel theyhave no influence at all over the contribution decision (vs. 23% for the LDI sceptics). This istrue in all the other regions, and 17% of the pro LDI Europeans feel they have no influenceat all on the contribution decision compared to 28% for the LDI sceptics

However, with regards to the other liability parameters analysed here, the pro-LDIrespondents are surprisingly very similar to the LDI sceptics:

They do not appear to value their liabilities more frequently than schemes that are not interested in LDI

They do not appear to have significantly different duration of liabilities fromschemes that are not interested in LDI

They do not appear to have a different time horizon for closing deficits from schemesthat do not support LDI




Comment


OverviewDanish and Swedish pension schemes are the most amenable to usingderivatives, while UK pension schemes are the most resistant

While futures are currently used by more than 50% of European pensionschemes, swaps are set to be the most commonly used derivative, with 68%of pension schemes using or planning to use them in the future

The most common role of derivatives is to hedge currency risk, followed byliability matching

Over three-quarters of pension schemes in Demark and Sweden can executeOTC transactions themselves. The majority of schemes in the UK and theNetherlands would prefer an asset manager to execute OTC transactions ontheir behalf

Part Four:Using derivatives in aninvestment strategy

Derivatives are an integral feature of many LDI solutions – typically to smooth out long-termcashflow or to create portable alpha strategies. But how amenable are pension schemes tousing them?

Type of derivatives usedWe asked pension schemes which of five types of derivative instrument they currently use, plan touse or would not consider using within their investment strategy. Futures see widespread use and are currently employed by more than half of our respondents across Europe. However, swaps,which are essential to long-duration strategies, are set to overtake futures, with 68% of respondentseither using or planning to use swaps within their investment portfolio.

Danish and Swedish pension schemes are the most avid users of derivatives. All respondents inDenmark reported very high usage of swaps and swaptions. In fact, all Danish respondentscurrently use swaps. This can be attributed to changes that took place in 2001, requiring pensionscheme assets to move in line with liabilities.

UK pension schemes appear the most resistant to using derivatives. In particular, 65% have ruledout the use of options and 75% of UK schemes have ruled out use of swaptions.

For explanations of all these derivative types – see the glossary on pages 42 & 43.

Futures (Exchange traded) UK NL DK SE Rest of Overall Europe

Currently use 34% 55% 56% 84% 67% 52%

Do not currently use, but considering 13% 10% 11% 5% 11% 11%

Do not use nor considering using 53% 35% 33% 11% 22% 37%

Forwards (OTC) UK NL DK SE Rest of OverallEurope

Currently use 29% 48% 62% 84% 61% 47%



Swaps (OTC) UK NL DK SE Rest of OverallEurope

Currently use 15% 42% 100% 78% 44% 39%



Options (OTC) UK NL DK SE Rest of OverallEurope

Currently use 17% 31% 56% 75% 59% 37%



Swaptions (OTC) UK NL DK SE Rest of OverallEurope

Currently use 3% 23% 78% 63% 26% 23%




Reasons for using derivativesThe most popular purpose for derivatives is to hedge currency risk – cited by 29% of respondents.However almost one in five (19%) of respondents say they use/would use them for liability-matching purposes. More than one in four schemes in the Netherlands look to use derivatives forliability-matching.

Using derivatives to ‘port’ alpha from one asset class to another is still a very limited practiceamong European pension schemes. The UK appears the most advanced in this respect, with one ineight (12%) of pension schemes saying they use or plan to use derivatives to implement portablealpha strategies.

Ability to execute OTC transactionsOn average only one in three (36%) European pension schemes can execute OTC transactionsthemselves. Denmark and Sweden report the highest capability with 78% of respondents able tocarry out OTC transactions in house compared with only 6% of UK pension schemes.

Outside of Denmark and Sweden, around one in five pension schemes say that internal rules donot allow them to execute OTC transactions. Fifteen percent of UK respondents cited regulatoryrestrictions – far higher than in any other country, although to our best knowledge there is noregulation that precludes UK pension schemes from using derivatives to any greater extent than in other markets.

This could be explained by the fact that the UK also had the highest percentage of respondentswho did not know, or felt it was not applicable, whether they could execute OTC transactions.This tallies with our earlier findings that show the UK to be the lowest user of swaps, swaptionsand options.

A significant number of respondents told us they did not execute in-house because their assetmanager carried out all OTC transactions for them. Indeed, of those who had an opinion, themajority of pension schemes in Europe said they would prefer a fund manager to trade OTCtransactions such as swaps on their behalf.

The exception was Denmark and Sweden, with two out of three (66%) pension schemes sayingthey would prefer to execute OTC transactions themselves.

Reasons for using derivatives UK NL DK/SE Rest of OverallEurope

Currency risk hedging 27% 26% 32% 33% 29%

Transition management / rebalancing portfolio 15% 16% 9% 14% 14%

Equity risk management 12% 12% 19% 24% 16%

Portable alpha 12% 7% 9% 6% 9%

Liability matching purposes 19% 26% 23% 11% 19%


Other 5% 6% 8% 10% 7%


Would you prefer an asset manager to UK NL DK/SE Rest of Overallexecute OTC transactions for you? Europe

Yes 55% 64% 31% 36% 48%

No 6% 26% 66% 28% 26%


Can you execute OTC transactions yourself? UK NL DK/SE Rest of OverallEurope

Yes 6% 36% 78% 48% 36%

No – the regulator would not let us 15% 4% 0% 4% 7%

No – internal rules would not allow this 22% 20% 11% 20% 19%


Other 11% 20% 0% 8% 10%


Schemes that are interested in LDI are far more inclined to use derivatives than pensionschemes that have no interest in LDI. For example, in the UK only 21% of pro-LDI schemeswould not consider using derivatives compared to 70% of LDI sceptics.

Pro-LDI respondents

LDI Sceptics


Many schemes are showing a high resistance to using some forms of derivative – althoughthey are a prerequisite for many LDI solutions. Further education from solution providerstherefore appears essential for schemes to grasp this important point.

The experience of Denmark, where swaps and especially swaptions, have been an integralpart of pension scheme management for the last five years, is encouraging in this respect.Many Danish schemes now appear very comfortable with the use of swaps and managingOTC transactions themselves.

In other markets, schemes appear willing to use OTC instruments but clearly need and wantthe support of an asset manager to assist in transactions.

Comment

Swaps UK NL DK SE Rest of TotalEurope

Currently use 21% 55% 100% 57% 43% 45%



Swaps UK NL DK SE Rest of TotalEurope

Currently use 11% 11% 100% 91% 47% 33%



*Based on a cross-reference of respondents who are considering, implementing or using an LDI strategy –



OverviewPension schemes are evenly divided in terms of whether they define riskprimarily in terms of investment underperformance or an increase in theirscheme deficit

More than 80% of schemes quantify the risk of underperformance relative to their benchmark – while 60% measure the risk of deterioration in theirfunding status

Only 14% of schemes quantify risk as the risk of the plan sponsor having to make forced or unplanned contributions into the fund

Part Five:Defining and measuring risk

Defining riskWe gave pension schemes a choice of four ways of defining risk. The first two relative toperformance risk (i.e the risk of assets not delivering an absolute or relative return). The other two relate to liabilities (i.e the risk of the funding status worsening or the need for additionalsponsor contributions).

Pension schemes in Denmark, Sweden and the ‘Rest of Europe’ appear most concerned aboutperformance risk – expressly the risk that assets will not meet an absolute performance target.This may be due to the minimum return guarantee integrated into some plans in these regions.

Pension schemes in the Netherlands and the UK seem marginally more concerned about liability-related risk; with around one in three schemes in these two regions defining risk primarily interms of deterioration in the scheme’s funding status. Pension schemes in these two regions werealso slightly more concerned than schemes elsewhere about underperformance of assets relative to a benchmark rather than against a targeted absolute return.

Only 14% of schemes across Europe consider unplanned contributions from the plan sponsor astheir primary risk

This prioritising of portfolio risks can be further contextualised when we see which risks pensionschemes choose to quantify. Performance of assets is a key priority for almost all pension schemes.But whereas pension schemes in most regions still focus on performance relative to a benchmark,pension schemes in Denmark and Sweden focus on absolute performance risk first and foremost.

Danish and Swedish pension schemes also appear the least likely to quantify the risk of a fundingdeficit, or risks relating to the plan sponsor. Indeed, the impact of the pension fund on the plansponsor’s financial performance was the least quantified risk across Europe, with only one in fourschemes taking it into account.


Which risks do you quantify? UK NL DK/SE Rest of OverallEurope

Investment performance relative to benchmark 80% 85% 56% 80% 81%

Asset absolute performance 48% 62% 78% 76% 63%

Funding status 64% 69% 44% 56% 60%

Contributions of the plan sponsor(s) into the fund 38% 23% 7% 32% 28%

Impact of pension fund on the plan sponsor(s) 24% 31% 7% 32% 25%financial accounts

How do you primarily define ‘risk’ in UK NL DK/SE Rest of Overallyour pension fund? Europe

‘Performance’ based risk

Risk of assets not delivering the targeted 24% 20% 43% 41% 30%

absolute return

Risk of investments underperforming the 28% 27% 21% 20% 25%

benchmark

‘Liability’ based risk

Risk of funding status deteriorating 32% 35% 29% 25% 31%

Risk of forced and unplanned contributions 16% 18% 7% 14% 14%

of the plan sponsor into the fund

Risk measurement toolsWe asked pension schemes how they measure risk in their portfolio. Standard deviation is the mostcommon measure of risk, being used by 78% of pension schemes surveyed. However, Value at Risk(VaR) is now used by two-thirds (67%) of respondents. We also asked over what time-frame, thesetwo risk tools are applied. In both cases, 75% of pension schemes that use these tools are lookingto measure risk over a period of 12 months or shorter. Danish and Swedish pension schemes appearto have the shortest time-frames for measuring risk, while the UK had the highest preponderanceof schemes looking to measure risk over periods of 2 years or longer.

Overall across Europe, pension schemes are still viewing risk primarily in terms of performanceagainst a market benchmark, not liabilities – although funding status is clearly starting to bea key risk concern.

It is interesting that only 14% of pension schemes quantify the risk of the sponsor having tomake forced contributions – even though the structure of pension schemes in markets suchas Denmark do not allow schemes to fall into deficit. Few schemes appear to believe the impacton the sponsor’s financial position to be a relevant concern for them. This could be related tothe fact that most of our respondents in these regions manage industry wide pensionschemes where there are a number of pension sponsors per plan.


Standard deviation – time-frame UK NL DK/SE Rest of Overallfor measuring risk* Europe

Less than 1 year 26% 35% 79% 26% 37%

Over 1 year 39% 41% 14% 53% 38%

Over 2 to 5 years 26% 24% 0% 16% 19%

More than 5 years 9% 0% 7% 5% 6%


Across Europe, pro-LDI pension schemes are marginally more likely to define risk interms of liabilities (eg the funding status deteriorating or the need for unplanned sponsor contributions) rather than in terms of asset performance.

*Based on a cross-reference of respondents who are considering, implementing or already using an LDI strategy – see Part 6 – Attitudes to Liability-Driven Investment.

Value at Risk – time-frame UK NL DK/SE Rest of Overallfor measuring risk* Europe

Less than 1 year 19% 37% 64% 35% 37%

Over 1 year 33% 44% 36% 40% 38%

Over 2 to 5 years 29% 19% 0% 15% 17%

More than 5 years 19% 0% 0% 10% 8%

*Based only on respondents who use these measures

Comment

OverviewSchemes primarily define liability-driven investing as using liabilities as thebenchmark for the management of scheme assets or the application of acashflow-matching strategy

Most schemes believe an LDI strategy should be applied regardless of whethera scheme is in deficit or surplus

The majority of respondents would want to use the full range of asset classesto construct an LDI solution. Only UK pension schemes are keen to includeleverage to address a deficit

Pressure from regulators to adopt LDI has been highest in Denmark and Sweden

Three-quarters of pension schemes want a return from LDI that exceeds theirliability costs

Schemes in Denmark and Sweden predict the highest take-up of LDI strategiesin their market, while pension schemes in the UK predict the lowest adoptionof LDI

Part Six:Attitudes to liability-driven investment (LDI)

Defining Liability-Driven InvestmentWhat pension schemes understand by liability driven investing can clearly cover a wide spectrumof objectives and strategies. We therefore gave our respondents five definitions to choose from whichcan be grouped as ‘traditional thinking’, ‘static thinking’ and – in three cases – ‘dynamic thinking’.

When asked to define their understanding of liability-driven investing, 44% of schemes across Europedefined it as using pension scheme liabilities as the benchmark for the management of assets.

Far fewer, 19% believe LDI automatically means a cashflow-matching strategy, while only one in10 schemes would restrict LDI to the use of LIBOR benchmarking and liability-matching usingderivatives. However, there was a relatively large minority of schemes in Denmark, Sweden andour ‘Rest of Europe’ category that believe LDI to be synonymous with the application of an asset-liability study.

‘Traditional thinking’Across Europe, only 14% of our respondents believe LDI to be the application of an ALM study –the traditional means by which liabilities have been measured against assets. We found that themajority of respondents that selected this definition also believe LDI has always existed (see table above right) and in most cases have no plans to implement any specific LDI strategy.

‘Static thinking’We have referred to cashflow matching as ‘static thinking’ because it offers no potential to addressa scheme deficit other than asking the sponsor to make an extraordinary contribution. This wasthe route chosen originally by the Boots* pension scheme, which is often regarded as the firstmajor move by a leading pension fund to adopt an LDI strategy.

In our survey, less than one in five pension schemes look to define LDI purely as cashflow matching,with the greatest support coming from the UK and ‘Rest of Europe’. However, we found that supportfor this definition of LDI was inversely correlated with enthusiasm to implement an LDI strategy.In other words, the more a pension scheme claims to be interested in LDI implementation, the lessit will consider LDI to be synonymous with cashflow matching.


Which most closely matches your UK NL DK/SE Rest of Overalldefinition of liability-driven investing? Europe

‘Traditional thinking’

Conducting an asset liability modeling 7% 13% 25% 23% 14%

(ALM) study then applying it

‘Static thinking’

Using cashflow matching strategies 22% 15% 7% 27% 19%

‘Dynamic thinking’

Using derivatives to match liabilities 9% 15% 18% 0% 11%and LIBOR as the benchmark for assets

Using liabilities as the benchmark for 53% 35% 36% 42% 44%the management of scheme assets

Managing the deficit over a short-term 9% 22% 14% 8% 12%and long-term basis

* The Boots pension scheme has moved from a “pure” cash flow matching strategy since, adding some risk into its portfolio.

‘Dynamic thinking’Our three ‘dynamic’ definitions all relate to an investment framework rather than a fixed investmentstrategy and all have the potential to improve a scheme’s funding ratio as well as meeting itscashflow requirements. Collectively these three definitions attracted between 50% and 70% of thevotes across all regions. It is clear that using liabilities as the benchmark is by far the most favoureddefinition – although a sizeable proportion of respondents in Denmark, Sweden and the Netherlandsbelieve LDI to be synonymous with absolute returns benchmarked against cash.

General views on LDIPension schemes were fairly evenly divided as to whether LDI is a new approach to managingpension assets or something that has always existed. However, only 10 per cent of schemes believethat LDI is a transitory fashion.

Only one in 10 pension funds across our European respondents think that LDI is a fashion.Whether they think that it has always existed or that it is a valuable change, there iswidespread agreement that LDI is a core strategy for pension schemes.

The role of LDIAcross Europe, pension schemes generally believe that LDI should be applied whether or not a fund is in deficit. In fact, our respondent schemes marginally believe LDI is more relevant ifa scheme is in surplus than if it is in deep deficit:

When should a pension fund apply an LDI strategy? Overall

If the fund is in deep deficit 67%

If the fund is marginally under funded 71%

If the fund is in surplus 79%


How do you view LDI generally? UK NL DK/SE Rest of OverallEurope

A new fashion – 13% 13% 3% 7% 10%who knows how long it will last?

Something that has always existed 46% 34% 45% 45% 43%

A valuable new investment strategy that 24% 6% 24% 37% 22%can be used alongside other approaches

A fundamental change in the way a 16% 44% 21% 0% 20%pension fund should conduct its overall investment strategy


Comment


Respondents were in far greater agreement that an LDI strategy should take into account all of apension scheme’s liabilities, with long-term cashflows taking precedence over short-term cashflows:

Constructing an LDI strategyIn terms of constructing an LDI strategy, over two-thirds of pension schemes (69%) believe it shoulduse all asset classes available. However, of these respondents, less than a third believe it should involveleverage as well. UK schemes were the most willing to use leverage to address a funding deficit, whileschemes in Denmark and Sweden saw the least need to use leverage.

The Netherlands had the highest percentage of respondents who believe an LDI strategy should onlyuse fixed-income assets.

Given the size of the UK deficits, it makes sense that UK pension schemes are the keenest touse leverage. However, there is an anomaly in the fact that UK schemes are the least keen to use derivatives, as we have seen in Part Four – Using derivatives (see pages 23 – 25).

Pressure to adopt LDISchemes in the Netherlands, Denmark and Sweden are reporting the greatest regulatory pressure to adopt an LDI strategy – with a almost a third of schemes (30%) in these last two countries saying theyare encountering significant pressure from the regulators to do so. Elsewhere in Europe, regulatorypressure is reported to be almost negligible.

What should an LDI strategy result in? UK NL DK/SE Rest of OverallEurope

Maintenance of current funding level status 49% 52% 65% 52% 53%

Reduction of the deficit 47% 35% 25% 48% 41%

Both of the above 4% 13% 10% 0% 6%

Which liabilities should drive an LDI strategy? UK NL DK/SE Rest of OverallEurope

All the liabilities of the pension fund 54% 55% 61% 75% 59%

Do not know 6% 3% 7% 7% 6%

The certain known cashflows 6% 9% 7% 11% 8%

(not inflation linked, for example)

The long-term cashflows 29% 27% 18% 7% 23%

The short-term cashflow payments 5% 6% 7% 0% 4%

Assets which should be invested in UK NL DK/SE Rest of Overallan LDI strategy? Europe

All assets available 43% 41% 66% 65% 50%

Fixed income assets 23% 41% 14% 14% 23%

All assets available and some leverage 27% 15% 7% 14% 19%

to make up for the deficit

Do not know 7% 3% 10% 7% 7%


Comment


The fact that UK schemes claim to experience very little regulatory pressure to adopt LDI issurprising given that the mark to market value of liabilities is now taken into account both to determine a scheme’s minimum funding requirement and the fee it should pay to the newPension Protection Fund (PPF).

The apparent lack of regulatory pressure may be due to the fact that UK schemes are underless time pressure than pension schemes in the Netherlands, Denmark and Sweden toaddress a funding shortfall (UK pension schemes are given up to 10 years to close a deficit).In addition, the moderate size of the PPF fee may mean it is currently of limited concern tomany schemes.

What regulatory pressure to adopt UK NL DK/SE Rest of OverallLDI have you encountered? Europe

No pressure 85% 46% 43% 97% 71%

A little pressure 12% 33% 27% 3% 18%

A great deal of pressure 3% 21% 30% 0% 11%

Comment

Uptake of LDI strategiesOnly 19% of the pension schemes we surveyed currently use an LDI strategy. Schemes in theNetherlands, Denmark and Sweden are most advanced in this respect, with around one in threeschemes already operating an LDI strategy.

However, if we add these figures to those schemes that are in the process of implementing an LDIstrategy or considering one for the future, then we see that almost half of our respondent pensionschemes are likely to be using LDI by some point in the future. The Netherlands is set to be thebiggest user with 66% of schemes either using, about to use or considering LDI. Denmark andSweden follow at 53% and then the UK at 44%. However in the rest of Europe, a vast 70% ofschemes have no plans to use LDI at all.

The apparent widespread lack of interest in LDI among the ‘Rest of Europe’ sample groupneeds to be compared with the response on page 32, where 45% of ‘Rest of Europe’respondents claim that LDI is something that has always existed. Many respondents in thisgroup may feel that LDI has already been an integral part of their investment managementfor many years, and that it does not need to be applied as a separate strategy.

Comment

Are you using an LDI strategy? UK NL DK/SE Rest of OverallEurope

Not considering using, and have no plans to 56% 34% 47% 70% 53%

adopt an LDI strategy in the near future

Already use an LDI strategy 13% 31% 33% 3% 19%

In the process of implementing an LDI strategy 3% 19% 10% 3% 7%

Currently considering using an LDI strategy 28% 16% 10% 24% 21%

Total of ‘pro LDI’ respondents 44% 66% 53% 30% 47%

Target return from LDIOf those schemes that are using or considering LDI, three-quarters are looking for a return fromLDI that exceeds their liability costs. This is consistent with our findings on page 31 where 67% of pension schemes defined LDI in a ‘dynamic’ manner.

Most schemes across Europe are relatively conservative, looking for an additional return of 1-2%after fees. However, schemes in Denmark and Sweden are significantly more aggressive and expecta return above liabilities of 2-4%. The Netherlands had the highest percentage of schemes onlylooking to target liability costs (35%).


Clearly, it will not be sufficient for providers of LDI strategies to offer cashflow-matchingsolutions. To meet market demand, they must integrate excess return as well.

This demand for additional investment return is particularly interesting given that – outsideof the UK – only a small proportion of schemes are reporting significant deficits. The demandfrom schemes in Sweden and Denmark for high excess returns of 2-4% may be due to thefact that a significant proportion of pension schemes in these two countries are offeringdefined contribution schemes with a capital guarantee and there is a strong incentive todeliver a return above the minimum guaranteed.

Professional support in implementing LDI

Consultants and actuaries are proving instrumental in implementing an LDI strategy for UKpension schemes, while schemes in the rest of Europe appear to make equal use of consultants,actuaries and their own internal investment management team. External asset managers have onlybeen employed by around one in four pension schemes to implement or advise on LDI.Investment banks are being used by 31% of schemes in Europe excluding the UK – but only 15%of schemes in the UK.

Only 15% of schemes are calling on their plan sponsor for assistance – although as we saw in ‘PartOne – Pension arrangements’, almost all sponsors are showing greater awareness of their pensionexposure (see page 8).

Who is helping you put together an LDI strategy? UK Rest of Europe Overall

Investment consultant / actuary 89% 45% 62%

In-house investment management team 8% 41% 27%

Asset manager 27% 21% 24%

Investment bank 15% 31% 24%

If you are using or planning to use an LDI UK NL DK/SE Rest of Overallstrategy, what level of return are you Europelooking to achieve?

Liability cost (net of fees) 17% 35% 27% 13% 25%

Liability cost +1% to 2% (net of fees) 66% 41% 9% 62% 45%

Liability cost +2% to +4% (net of fees) 17% 24% 64% 25% 30%

Comment


Future adoption of LDI

Finally, we asked pension schemes what percentage of schemes in their country are likely to adoptLDI in the next five years (i.e by 2011). On the basis of these responses, take-up of LDI is set to behighest in the Netherlands, Denmark and Sweden. The majority of respondents in these marketsbelieve that LDI will be used by well over half of their compatriot schemes by 2011.

In the UK and the rest of the Europe, take-up is predicted to be more muted. Most respondentsbelieve that 50% or less of pension schemes in their country will be using LDI by 2011. It isnotable that no UK respondent thought that more than 75% of UK pension schemes would beusing LDI by 2011.

Obstacles to adopting LDIWe also asked all schemes what are the biggest obstacles to implementing an LDI strategy. Satisfactionwith the current strategy is seen as the primary reason for not implementing an LDI strategy – butaround one in four schemes cites lack of knowledge as the primary hurdle. Regulatory constraintsare only considered a hurdle by one in ten schemes.

Given the proportion of UK schemes in deficit, it is surprising that such a high percentageclaims to be happy with their current investment strategy. It is also remarkable that arelatively low proportion of schemes cite lack of knowledge about LDI as an issue, given that the term was almost unknown among the wider pension market only three years ago.

Nonetheless with one in four pension schemes across Europe believing they require moreknowledge about LDI, there is clearly still a substantial amount of education to be done.

It is notable that the countries that anticipate the highest take-up of LDI are those where the funding regulation is based on mark to market of the liabilities.

Hurdle to implementing an LDI strategy UK NL DK/SE Rest of OverallEurope

Lack of knowledge of LDI 27% 35% 30% 7% 24%


Regulatory situation 9% 0% 15% 14% 10%

Satisfied with current strategy 40% 35% 40% 50% 41%

Too underfunded to afford LDI 12% 4% 0% 4% 7%

What percentage of pension schemes in your UK NL DK/SE Rest of Overallcountry will adopt LDI over the next five years? Europe

Less than 25% 23% 5% 7% 50% 18%

25%-50% 54% 14% 22% 30% 32%

51%-75% 23% 36% 0% 0% 19%

More than 75% 0% 45% 71% 20% 31%

Comment


Pro-LDI respondents

LDI sceptics

Pressure from regulator to adopt LDI UK NL DK SE Rest of TotalEurope

Some pressure (a little or a great deal) 21% 67% 88% 75% 0% 44%

No pressure 79% 33% 12% 25% 100% 56%

Pressure from regulator to adopt LDI UK NL DK SE Rest of TotalEurope

Some pressure (a little or a great deal) 11% 36% 0% 33% 5% 16%

No pressure 89% 64% 100% 67% 95% 84%


64% of pro-LDI respondents believe that LDI constitutes a valuable new investmentstrategy and 31% believe it has always existed

55% of LDI sceptics believe LDI has always existed

Although pro-LDI respondents (47%) usually consider all their assets to be for an LDIstrategy, a third have preferred to use their fixed income portfolio (compared to only 16% for LDI sceptics)

On average across Europe, a small majority of pro-LDI respondents have not received anypressure from the regulator to adopt LDI (56%) compared to a very strong majority for theLDI sceptics (84%). The picture differs strongly when we look at individual markets:

In the Netherlands, Denmark and Sweden, many pro-LDI respondents (more than 67%)all report pressure from the regulator to adopt LDI. Whilst, in the same markets, LDI sceptics have in majority (more than 64%) no pressure from the regulator.

This could be explained by some pension schemes taking action to implement LDIstrategies ahead of the regulatory changes in the Netherlands and Sweden. The LDI sceptics may well report greater pressure once these regulatory changes are implemented

In the UK, although pension schemes adopting LDI report more pressure from theregulator (21%) than the LDI sceptics (11%), a strong majority of pro-LDI pension schemes (79%) consider they have received no pressure from the regulator adopt LDI

There is however a clear correlation between the pressure from the regulator and the LDI uptake



Conclusion


The findings in this survey show that while LDI is being discussed across Europe, actualtake-up and perception of what it should entail vary widely and there are some importantregional differences in attitude to be aware of.

As yet, LDI has made a relatively light impact. On average, fewer than one in five schemes arealready using an LDI strategy. However, if every scheme that intends to implement an LDIstrategy does so, then LDI is set to be part of mainstream pension management – perhaps in aslittle as two to three years.

A regulatory impetusIf we look at the markets where take-up of LDI appears to heaviest, it is clear that adoption ofLDI is being driven foremost by regulation and compulsion – not persuasive marketing.

This is notable in Denmark, where schemes have been obliged to track assets against liabilitiesfor almost five years and also in Sweden, where new funding regulation comes in this year(2006). The strict funding requirements to be implemented under the nFTK regime in theNetherlands in 2007 – dubbed the most stringent pension regulations in Europe – have alreadyhad a substantial impact as we can see from our findings – with around three-quarters of Dutchschemes extending their fixed income duration and many schemes planning far greater use ofderivatives to assist with liability matching.

Conversely, the UK would seem to be in greatest need of risk control given the prevalence ofscheme deficits. Yet it is here that we see the greatest resistance to using the derivative instrumentsrequired to execute an LDI strategy. The UK also demonstrates the greatest scepticism towardswidespread adoption of LDI. While nearly half (44%) of our UK respondents say they use orintend to use LDI, most pro-LDI supporters believe that LDI will be implemented by half or lessof all pension schemes in the UK between now and 2011.

Going beyond cashflow matchingIt is clear that most pension schemes do not want simply to match their liability costs – they wantexcess return as well, which suggests that some form of alpha generation should be integral to anyLDI solution.

In our view, the success of LDI partly lies in communicating that it is not simply about cashflowmatching and that it can deliver higher returns than most pension schemes may currently assume.As this point becomes more widely understood, we would anticipate much greater interest in LDI strategies across a number of markets – especially those such as the UK where deficits are a significant problem.

Embracing new ideasThe majority of schemes across Europe are willing to use all available asset classes to devise anappropriate LDI solution – including equities, fixed income and alternative asset classes. TheNetherlands is the only market where a sizeable proportion of schemes want to use fixed income only. It also appears that pension schemes are generally willing to embrace new ideas thatcan facilitate better investment management. Swaps – the key means of achieving long durationand therefore better cashflow matching – were barely talked about in the pension industry fiveyears ago. Now two-thirds of our respondents are either using them or planning to use them.

Conclusion

The duration challengeThe general willingness across Europe to use swaps is also gratifying given that our survey showsthat there is a stark mismatch between the duration of assets and the duration of liabilities. Wehave seen that schemes have made a significant effort to extend duration – but this is still too little.Given the continued lack of sufficient long-duration issues in either government or corporatebond markets, we anticipate huge growth in the swaps market over the next three to five years.However, pension schemes in some markets, notably the UK, will clearly need further educationabout these instruments in order to feel comfortable with them.

Defining riskOur survey clearly shows a sea-change in how pension schemes are defining risk. Granted, themajority of schemes in Europe are still focused primarily on the risk of underperformance relativeto a market benchmark but a sizable proportion are also now focused on absolute returns and therisks relating to their funding status.

Working with the sponsorWhat is perhaps still surprising is just how little notice schemes take of the impact of assetperformance on the scheme sponsor. Almost all schemes say that their sponsor is far more awareof their pension exposure than they were five years ago – but only 25% of schemes quantify theimpact of the pension fund on the sponsor’s balance sheet.

Likewise, 70% of schemes said they felt they had no or only a modest influence on the level ofscheme contributions. Granted, in markets such as Sweden, Denmark and the Netherlands,contributions are set by regulation and therefore neither the pension scheme nor the plan sponsorhas much control over them.

However in the UK, contribution levels are open to revision by scheme and sponsor. Given thatschemes are given the responsibility of managing the assets, it seems odd that they appear to haveso little say in this other important aspect of scheme funding.

So while it has always been laudable that pension schemes are managed independently of thesponsoring company, there perhaps could be significant benefits if schemes and sponsors –particularly in the UK – work in a greater spirit of co-operation and communication. By sharingresponsibility for the level of pension contributions, there could potentially be fewer cases wherethe sponsor has to make forced and unplanned cash injections into the scheme.

In turn, by recognising the scheme’s financial impact on the sponsor as a key risk, the pensionfund can increase the likelihood of the sponsor retaining the financial strength to help fund thescheme in the future.


Appendix The regulatory landscape – a brief overview

Many of the responses to our survey were influenced heavily by the regulatory environmentin which each pension scheme operates. It is therefore valuable to summarise some of the key regulatory factors that apply to pension schemes in each market – although this is not exhaustive.

Some similarities:

For corporate pension schemes of listed entities, the corporate accounting framework is thesame across Europe – International Reporting Financial Standard. This became mandatoryas of January 1st, 2005. (Non-listed entities with listed debt will be submitted next year). In theUK, companies apply either IFRS or FRS17 for their pension recognition. These standardsrequire the disclosure (at least in the notes for IFRS) of the market value of pension liabilitiesand assets. Hence, from one year to the other, the pension fund status (whether in deficit or insurplus) will move as per changes in the mark to market of the value of assets and liabilities.

There is an evolving regulatory framework across Europe. Changes have taken place inDenmark in 2001, in the UK and Sweden this year, in the Netherlands next year. Insuranceregulated pension schemes (such as in Germany) will be subject to the new European InsuranceDirective when it is implemented.

External scrutiny. Listed corporations with significant pension exposure are under a systematicreview of the pension fund volatility by the financial community (rating agencies, financialequity and credit analysts).

Some differences:

The minimum funding ratio required by the regulator

In France, Germany and Sweden, there is not necessarily a requirement to segregate assets in a dedicated pension vehicle. Hence there is no direct funding requirement in those instances.

In the UK, a deficit can be tolerated (to the extent that the pension fund can demonstrate that it can solve the situation in a reasonable time-frame, up to 10 years).

In other countries (Netherlands, Sweden, Germany and Denmark) , the regulations are close to insurance regulations where a small surplus is required above the value of the liabilities.

The discount rate used to value the liabilities for minimum funding ratio

Traditionally based on a fixed rate in continental Europe (with some revisions of the discountrate possible but not automatic).

Based on a rate related to a single marked to market interest rate in the UK.

Based on the yield curve for the Netherlands, Denmark and Sweden.

The asset allocation rules

In Denmark, the Netherlands, Sweden, investments require a minimum solvency (buffer) which depends on the risk of the assets.

In some countries such as Austria, Belgium, Germany and Norway there are strict limits to percentages of assets which can be held in investments considered risky.

In contrast in the UK, there are very few restrictions.


Glossary of terms

Absolute return – Investment performance based on generating a specific positive return ratherthan a relative return against a market benchmark

Asset Liability Modelling (ALM) – Analysis undertaken to see whether the assets of a DBpension scheme are sufficient to meet its future liabilities. This analysis may be then used todetermine an appropriate investment strategy.

Defined Benefit (DB) Pension Scheme – A pension scheme where the benefits given to schememembers are determined by a fixed calculation based on the member’s number of years ofservice and salary. The risk for meeting the agreed level of benefits is borne by thescheme/sponsor. Also known as a ‘final salary’ scheme. Liability-driven investing is mostrelevant to DB pension schemes.

Defined Contribution (DC) Pension Scheme – A pension scheme where the member – andpotentially the employer – invest contributions. The benefits received by the member onretirement will be determined primarily by the level of contributions made, the performance of the chosen investments and the means choosen to generate an income from the accrued fundon retirement. The risk of funding is therefore wholly met by the scheme member. Also knownas a ‘money purchase’ scheme. Liability-driven investing has no direct application for DCpension schemes.

Discount rate – The assumed future rate of investment return used to determine the currentvalue of assets required to meet a DB pension scheme’s future liabilities.

Duration – A measure of the price sensitivity of a fixed income portfolio to a change in interestrates, expressed in years.

Exchange-traded transaction – A derivative trade that takes place on a centralised exchange

FRS17 – The accounting standard used in the UK, which sets out how companies and otherentities report the cost of providing pensions and other post-retirement to their employees.Broadly replicates the standards used in IAS 19 except it does not permit the spreading ofactuarial gains and losses in the same way. Requires scheme assets to be valued ‘marked tomarket’ and liabilities to be valued using a discount rate based on the prevailing AA corporatebond yield.

Forward – A futures contract that is tailor-made for an organisation and which cannot normallybe traded. Commonly used by pension schemes and other large organisations to managecurrency risk.

Future – A legally-binding, tradable contract whereby the buyer agrees to purchase a certainamount of a commodity or financial instrument at an agreed ‘exercise’ price on an agreed datein the future. Designed to remove future price uncertainty and commonly used by pensionschemes to remove currency risk. Because futures contracts can be traded on a central exchange,the have an intrinsic value that can rise and fall with the price of the underlying commodity.

IAS19 – The international accounting standard applied across the EU as part of IFRS (see below),which sets out how companies must report the cost of providing pensions and other employeebenefits. Has very similar requirements to the UK’s FRS 17 accounting standard (see above) butallows actuarial gains and losses to be smoothed out more through amortisation or by ignoringthem if they fall within a 10% corridor.

IFRS – International Financial Reporting Standards – the standardised accounting standardsintroduced to the EU in 2005.

LPI – Stands for ‘Limited Price Index’ – an index for inflation used predominantly by pensionschemes in the UK, which typically limits inflation-linked changes in benefits to between 0%and 5%.


Mark to market adjustment – of the value of an asset (e.g. pension fund assets) for accountingpurposes to reflect current market prices.

Minimum Funding Requirement – The minimum level of assets an individual pension schemeis obliged to retain in order to meet its liabilities.

Minimum Funding Ratio – The minimum level of assets an individual pension scheme isobliged to retain in order to meet its liabilities – expressed as a percentage of its liabilities.

Minimum Solvency Margin – A minimum surplus of assets over liabilities that some pensionschemes are obliged to maintain to demonstrate they can meet their liabilities.

Option – Similar to a futures contract (see above) with the crucial difference that the buyer hasthe right but not the obligation to exercise the contract. Provides greater flexibility should themarket price of the instrument/commodity fall below the agreed exercise price.

‘Over the counter’ (OTC) transactions – Derivatives trades that do not take place on a centralexchange but directly between dealer and investor.

Pension Benefit Obligation (PBO) – The present value of a pension scheme’s benefit payments.

Portable alpha – A derivative-based method of transferring returns generated by activeinvestment skill (‘alpha’) from one asset class/market onto another - typically lower risk - assetclass. Often used with the objective of generating absolute returns and minimising directionalmarket risk.

RPI – Standard for ‘Retail Prices Index’, the key measure of inflation used in the UK andcommonly used by DB pension schemes to ensure that pension benefits keep pace with the costof living.

Sponsor – The corporate or other entity providing a pension scheme for its employees. It isultimately the sponsor’s responsibility that a pension scheme is sufficiently funded.

Standard deviation – A common measure of investment volatility which gauges how far aninvestment’s dispersal of returns deviates from its mean return. Used primarily in measuringrelative risk.

Surplus – Where the value of a pension fund’s assets exceed the current known value ofits liabilities.

Swap – A derivatives contract where a variable stream of payments is exchanged for a fixedstream of payments to provide an investor with greater certainty about their future cashflow.The most common type is an interest-rate swap where a variable rate of interest (e.g. LIBOR)on a nominal amount of capital is swapped for a fixed rate of interest.

Swaption – An option on an interest-rate swap, that gives the buyer the right – but not theobligation – to enter into an interest-rate swap agreement by some specified date in the future.

Value at Risk (VaR) – A risk measure technique which analyses historic trends and volatility toestimate the likelihood that an investment’s losses will exceed a certain amount. Used primarilyin measuring risk in absolute return strategies.

Yield curve – The variation in the yield of bonds of comparable credit ratings across differentmaturities. Yields tend to rise as bond maturities lengthen. An ‘inverted’ yield curve indicatesthat yields on longer bonds are lower than on shorter maturities.


Notes

JPMorgan Asset ManagementFinsbury Dials20 Finsbury StreetLondon EC2Y 9AQ

www.jpmorganassetmanagement.co.uk

The information contained in this document is based on our understanding of law, regulation and taxationpractices as at 06/06. JPMorgan Asset Management Marketing Limited is regulated in the UK by the FinancialServices Authority. Registered in England No. 288553. Registered office: 125 London Wall, London EC2Y 5HA.Issued in other jurisdictions by JPMorgan Asset Management (Europe) S.a.r.l.

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