XPS Pensions Group plc (406.F) Earnings Call Transcript & Summary

Good afternoon, everyone. A very warm welcome to this first XPS live event of the year, Investment Outlook for 2022. I'm Adam Gillespie, it's a pleasure to be your host for the next 60 minutes. I'm delighted that you can join us today and I'm delighted that we have over 350 people attending. And that affects there so many big investment newscast that is out there at the moment. I'm sure some of you may have seen already, U.S. equities had the worst start to the year since the global financial crisis. Central banks around the world are raising interest rates trying to battle sky-high record-breaking inflation. And those market events are happening against the geopolitical pressures, most notably the war developments in Ukraine. But the good news is our experts on hand are here to make sense of all this for you and also what it means for your scheme and what actions you could take. And whilst it's important we wanted to focus on the headlines, it's also important to remember there are other key investment things on people's agenda for 2022. For example, what will new funding code mean for the investment strategy and risk management? How do you probably assess fund management costs will be getting value for money? Then your DC arrangements, how do you best utilize your investments to improve member outcomes. Now covering all these topics, we have 5 shortest [indiscernible] talks from our XPS experts as well as special guest, Neil Bull from The Pensions Regulator. And we'll take some questions as we go along, but we'll also have our Q&A session at the end. Now just before we start, I've got a bit of housekeeping. Our aim is to finish at 4:00 p.m., no later. For those who haven't used our system before, all the screens on the -- in front of you are movable and resizable. And if your screen freeze at any moment, please refresh your browser [ and is ] done by pressing F5. And if any questions for our speakers, please submit the use the Q&A panel. So let's kick off with our first speaker, Alasdair Gill, Head of Equities here at XPS, but also unofficially our very own Mystic Meg. Ali is going to give a quick recap of markets last year, but more importantly, he's going to be dusting off his crystal ball to see what we might install over the next 12 months. Ali over to you.

We want no pressure here then, Adam. Thanks very much. In the next 5 minutes or so, I'm just going to give you a quick recap of where we are in terms of the economy and markets. I'll highlight key areas of focus as we see them for U.K. pension schemes. And I'll start with the U.K. economy, which rebounded very quickly as the rollout of vaccinations quickly gathered momentum last year. And indeed, we ended the year with a GDP index of economic output shown here above the level it was going into the pandemic. So we're pretty much caught up. And similar charts in the U.S. actually show that their economy is pretty much back on trend, which is an amazing feat, I think you'll agree. And Chart 2 shows the impact of this recovery on inflation in the U.K., where it surpassed the levels of 2011 to make it the highest since the CPI was first published and certainly the highest for 30 years. As many of you know, it's long-term inflation that has a larger impact on pension scheme funding. But this also rose by about 0.5% over the year with breakeven inflation as it's known settling close to 4%. And so the question vexing markets towards the end of the year was how permanent or transient the size would be. And as ever, there was disinflation and inflation factors around, but inflation factors certainly in things like food prices and energy, certainly dominate over the latter half of 2021. And it certainly seems to us that that's going to persist into -- towards the middle of 2022. Although we do think inflation would fall back towards the middle of the year. And this does have potential implications for U.K. pension schemes. If we do fall back at a level higher than we used to, many pension scheme increases are capped at 2.5%. So there's a potential for year ahead, if you've got inflation hedges in place, you might have too much inflation hedge and that certainly is the case for a client we reviewed and where we reviewed our hedge late last year. Now what did the government -- the Bank of England do? Well, we saw last week, the latest rise in interest rates to 0.5%. And it also saw the end -- effectively the end of the government's quantitative easing policy. They also announced that they will be selling their stock of GBP 20 billion of corporate bonds into the market over the next 18 months or so as well as not reinvesting our Gilt holdings as they mature. So these measures should apply upward pressure on long-term interest rates, which may not be a bad thing for pension scheme liabilities. And at last, it seems that we're at a turning point for interest rate cycle. So what about equity markets? Well, as this first chart shows, the developed markets continued to rise strongly last year and even the U.K. participated, having been a laggard since 2016. And although we did see the material pullback in the market in January, as Adam mentioned, equity markets are still elevated, in particular developed markets compared to emerging markets, that valuation differential and emerging markets on the pink line here, that differential is as high as it has been since 2014. So despite the higher risks of investing in emerging markets, it does feel to me this differential is more than compensating investors for that additional risk. But we also need to put the recent falls in the markets into perspective. And this base by various valuation metrics, developed equities, particularly U.S. equities are as expensive as they have been since the year 2000 in the dot-com bubble. This chart shows the well-used, cyclically adjusted price earnings ratio devised by Professor Shiller of Yale and -- in blue. And granted these high valuations have been supported by the low interest rate environment and low and falling interest rates as you can see in pink. But as we are going into a tightening phase with interest rates starting to go up in the U.S. as well as here. And that support for equity markets will fall away. But that said, equity -- it is earnings season, and we've seen some pretty good results in some sectors like energy, for example, which will support markets. And there are still plenty of investors out there buying on dips. So I'll conclude with some thoughts as to areas of focus for pension schemes. Firstly, on hedging, many will have inflation hedges in place. But even if you have -- particularly if you put that in place a few years back, it may be worth checking that you still are suitably hedged, and you've got the right level of protection in place there. On interest rates, how exposed are you to the rising interest rate environment. And hedges in place may be neutralizing this, but there could be an impact on your growth portfolio, both equities and fixed income growth assets. A scenario model could help identify any particular scenarios could be damaging for your portfolio, and Sian is going to cover this in a bit more detail in the next slot. And finally, the elevated level of equity markets. You may have been a strong beneficiary of this in your scheme and it may be time to take stock. Some diversifications in emerging markets could reduce your reliance on particularly large cap U.S. companies. And another option maybe to consider a more sustainable approach to investing, which could protect you against the risk of a downturn impacting those companies not well aligned with the transition to net zero. And finally, our portfolio could be ready for more diversification into areas that are less correlated with economic growth and more income focused, which could provide a more resilient funding position. Well, to summarize, the markets do appear to have reached a turning point in interest rate cycle. And so you should ensure your portfolio is suitably positioned and risk controls in place. But however, the truth is we never really know for sure what the markets have in store for us. And issues like the crisis in Ukraine have the potential to destabilize global markets materially. So it does pay to be vigilant and get ready for a bit of a roller coaster ride, I think, in 2022.

Great. Thanks, Ali. As you say, lots of uncertainty ahead. And even the best crystal ball out there is going to be a little bit hazy. But notwithstanding that, I've got a question from the audience for you on this. Just how high do you think inflation will get?

Well, we saw inflation just come back today in the U.S. at 7.5%. And I think that's probably going to be the peak in the U.K. as well. Certainly, the Bank of England expect that peak to be in April when the price cap -- energy price cap moves up. So I think we should probably peak in April just above 7%, and it will probably fall back from there to the rest of the year.

Great. Thank you. Before we go on to our next speaker, I want to ask a polling question from the audience, please. So everything you've heard from Ali there, for your scheme which are the risk factors the market forces you're worried about the most over the next 12 months? Is it inflation, interest rates, equities, ESG and climate risk or something else? And if you can select your answer and more put in scroll down and make sure you hit submit, that would be great. [Voting]

And just while I wait for the results to come in, just to remind you that also we've got a Q&A session at the end, plenty of time for questions. So please also, once you've voted, please start submitting your questions using the Q&A button. So responses coming now, won't be much longer. Okay. Great. So we've got a bit of a mix here, which I suppose reflects the fact that actually although [indiscernible] markets inflation, there's still a mix, going to show that actually different schemes at different stages with their risk profile and their journeys. But I think that leads nicely on to the next slot, which is whichever those risks that Ali talked about you're worried about the most, our next speaker, Sian Pringle, who is the Head of Strategy here at XPS, will talk about what actions you can take over the coming months to help mitigate those concerns. Sian, over to you.

Thanks, Adam. So today, I'm going to be talking to you just about how current market conditions, as Adam mentioned, may want you just looking and reviewing your current asset strategy discovering not only what the risks might be, but actually could there be some opportunities out there for your scheme. And as Ali mentioned, equity markets started 2022 at near all-time highs, and schemes that are still on risk have clearly benefited from this and are likely to have seen their funding levels increase. The data from the PPF 2021 Purple Book shows this year, with the aggregate funding level of DB pension schemes increasing over the last 3 years on both the Section 179 valuation basis, which is the likelihood of whether a scheme would need to call on the PPF in the event of the employee becoming insolvent, but also on a proxy buyout basis. And these figures might not even be taking into account the longer-term impact of COVID-19. Our longevity protections carried out at XPS suggests that U.K. pension schemes could actually be overstating their liabilities by between 1.5% and 3.5%. So actually, the impact on funding levels could be even higher than we think. Plus, with higher rates since the data that was used for this publication, this trend is likely to have continued. So for those schemes, you've already seen an increase in your funding level and you're still taking risk in your growth assets, particularly with the recent market pullback, this could be a time to consider banking those gains and taking risk off the table. But how much risk are you currently taking, and therefore, how much can you afford to take off? So it's as important as ever to make sure that you've got a plan in place, knowing what your long-term funding target is and how you plan to get there. Rerunning any previous journey planning analysis and reviewing the trustees' beliefs will really help you decide if you can actually afford to de-risk and take advantage of that improved position. But then I guess the next question is how should you look to try and measure your risk? So this page shows, there are clearly several ways that you could look to try and measure and analyze risk. And hopefully, some of these are familiar to you. And Neil, later on actually will be giving some insight into The Pension Regulator's proposed approach. But we're now starting to see some new ways to consider risks coming into the market. If we look at longevity risks, there are now ways to use scenario testing to consider the impacts that longevity might have on your scheme under a range of outcomes. And you can also combine these scenarios with the traditional financial risks too, to truly gain an insight into the combined risks within your scheme. Now we're also seeing a range of new ways to try and measure ESG or climate change risks, such as the PACTA stress test, that stands for the Paris Agreement Capital Transition Assessment. It's a new way to measure your portfolio's alignment with various climate scenarios that are all consistent with the Paris Agreement. So although all these models can give the trustees or, you as a trustee, an idea of the magnitude of risk within your scheme, all risk measures do have pros and cons. And overall, I think it's arguably more beneficial to consider the relative differences between the measures or between alternative asset allocations rather than just looking at the absolute risk level in isolation. So after revisiting your journey plan, analyzing the risk within your portfolio, hopefully, you're now able to decipher what is that concerns you the most going into 2022. But perhaps despite those concerns, given the market conditions, I'm hoping we might be able to show you that there could be some opportunities out there that could be beneficial for your portfolio. So are you still exposed to the volatility with an equity market, and was that causing you concern as the majority of you said in the poll earlier? Perhaps you might want to consider replacing your traditional equity exposure with equity protection strategies. So these are strategies where giving away some of the upside potential in order to replace -- in order to protect the scheme on the downside in the event that markets fall. Or maybe increasing your allocation to contractual income funds. So with a higher proportion of value coming from the underlying income streams, these funds are inherently less volatile. Or is it inflation that's causing you concern? Well, if that's the case, the trustees might want to consider an allocation to real assets, perhaps real estate. Historically, many tangible assets have fared really well in high inflation markets and long lease property with its inflation linked income streams could be really beneficial in the coming years. It's also worth noting that we now think it's a good time for you to review your inflation hedge. You might find that you're actually hedging more inflation than you were originally targeting. Or are you concerned about the new rate rising environment that we find ourselves in? So for some schemes that aren't already invested in LDI, this may be the news that you've been waiting for and could create an opportunity to hedge your liability interest rate risk at a relatively cheaper level than previously available. But for pension schemes in general, this should be good news assuming this does actually result in actual increases in longer-dated gilt yields. However, if there are any trustees out there currently considering implementing any changes or perhaps derisking away from growth, you might want to consider the use of more short-duration credit assets, perhaps asset-backed securities, increasing your floating rate exposure and making sure that you're not locking into current rates for too long. Or finally, is it climate change and the risks associated with that? Hopefully, we all know now that ignoring ESG metrics and climate change is clearly a risk. But could actually investing sustainably provide opportunities? With the evidence now coming through, I think it's clear to me that the companies solving some of the world's biggest problems and challenges could actually be best placed to grow in the future. And in almost every asset class, there's already options to invest in funds with a sustainable focus and more coming to the market each month. So these are funds looking to the longer term, avoiding sectors or practices that are exposed to excessive risk or those that specifically incorporate long-term themes, such as climate change. At XPS, we've now carried out market research in active equities, credit and multi-assets to define and rate what we call sustainable designated funds. These funds only include companies employing sustainable practices, with the added benefit of selecting companies that are actually best placed to benefit, for example, from the transition to a low-carbon economy over the longer term. Or another example is in renewable energy infrastructure funds, funds that are ensuring they are at the forefront of our global energy and storage challenges. These funds and the companies within them can provide opportunities not only to invest sustainably, but also to benefit from the growth that they're expected to achieve as the world looks to find ways to try and tackle our problems. Thanks, Adam.

Great. Thank you, Sian. Obviously, lots of options there. But as you say, clearly not one right option for every scheme, obviously, really important to understand your own schemes risk levels and position before taking any action. I've got one question for you that that's come in on your last point there. How do I balance my fiduciary duty as a trustee before investing in sort of climate risk sustainable funds? Am I in risk of overstepping the line?

It's a good question and certainly one that comes up regularly in trustee meetings. My initial overall answer really is that I don't believe those 2 things should be mutually exclusive. And I'd argue that the precedent has already been set when it comes to schemes and trustees investing in funds that might not necessarily just be looking to maximize returns. For example, anyone invested in LDI, those funds are predominantly there to minimize risk and mitigate risks particularly and behave how your liabilities are. So I think taking the extra step further to invest in funds that are looking to mitigate ESG risks and climate change risks is really along the same vein. And on top of that, I mean, I think we've already had and seen the high-profile quotes from Pensions Minister, Guy Opperman. I think he actually announced at a conference that trustees who were ignoring ESG and climate-related risks might actually be going against their fiduciary duty. So I think for any trustees that are worried about that balancing act, hopefully that gives them a bit of comfort that I think investing and considering these risks is actually in line with your fiduciary duty.

That's great. So on to our next slot, I'm delighted to introduce Neil Bull from The Pensions Regulator. Neil's going to talk about the world view from the regulator, how he sees it, building on some of the comments and risks that Sian has just talked about. But also about how risk management and investors might evolve over the coming months and years as the new funding code is eventually published. Neil, over to you.

Great. Well, thank you, folks, and thank you so much for inviting me to speak and comment this. Wonderful to have so many people listening in. And I'll do my best over the next 5 minutes to give you a little bit of a flavor for the regulators view of the world, what might be coming to some pension schemes soon. But more importantly, a great chance for you to ask your questions. I don't know there's a bit of a session later on to try and cover those. So you'll be really to know I only have 2 slides, and I'm just going to spend a little bit of time talking first about the messages we give to the industry on a yearly basis. So we did that through something called The Annual Funding Statement that you folks might be familiar with. And about 2 or 3 years ago now, we introduced investment themes and expectations into The Annual Funding Statement. Historically, it used to be very much focused on kind of the actuarial and funding side. So I thought it was useful just to pull those out and put them up on the page. And this is kind of what we expect to all schemes to do. There're some additional expectations for schemes with -- in particular circumstances. But hopefully, this chimes with quite a lot of the stuff that Sian mentioned earlier. So let's just run through that quickly. So we hear a lot about schemes looking at a long-term funding target. But from an investment point of view, what does that look like from an investment perspective. What I mean by that is an asset allocation, not that you're targeting now, but that you hope to get to when your scheme is in kind of that end game significantly mature point. So that's really important. I think it's really important to set a destination for a scheme. It doesn't mean you have to get that straight away, but to set that plan. And then set a journey plan of how to get there, how you expect it to get towards that long-term target. And we see -- in terms of best practice, we see schemes doing that and articulating that. Then there's a question of risk, which I know plays into a lot of the themes of the conference today. But quantifying the impact of downside risk. Unfortunately, we've seen a real-life example of that recently with COVID and previous examples of the financial crisis and other scenarios, where really funding levels have been tested, sometimes for a short period, sometimes for a longer period. So quantifying that downside is really important. And again, we see a lot of schemes doing that as well. The final one is probably the one where we'd like to see the greatest sort of improvement or increase in activity among schemes and their trustees. And that's once they've taken the level of downside risk to have that conversation to engage with their employer and really asked that question, can the employer support that level of downside investment risk? And if they can, then that's fine. And if they can't, what can you do about it, what are some of the risk mitigation exercises. So we sort of see some of the better schemes doing that, but lots of opportunity and room for improvement there as we look at the industry on the whole. And certainly, that's one of the things we're keen to introduce in the new funding code. So with that in mind, let me just have a quick slide on the DB funding code. Let me say a couple of things before I start. We are in -- this is a consultation. We are -- we've already had one consultation. We will have another consultation on the DB funding code later this year. But in the first one, we introduced a few points that I think are quite relevant for today's discussion. What is this idea of complying with the new code through something called Fast Track and Bespoke? What is that? Well, Fast Track from an investment perspective will be a clear sort of set of expectations from an investment point of view, quantify. But what if you pass those, you kind of sail through the regulator's regime. And then there's the Bespoke side, and that's deliberately there for people those want to follow a different route, allows them to comply. But as a regulator, we're looking for a greater level of explanation in terms of that. In terms of investment risk, under Fast Track, we do have to set a standard across the industry. Again, schemes can go down the Bespoke route if they want. We proposed in the first consultation to use the PPF stress test as a way of standardizing that stress across the board. Once we've done that, then we'll set out in the code our expectations of how much investment risk we think is acceptable under Fast Track, and that is likely to be a function of the covenant strength and the maturity. But all of those centers around trying to get schemes to that low risk position when they get to a point of significant maturity. And we think that, on the PPF stress test looks like a number of around 4% to 5% to be decided in the future. Liquidity is important. I'm not going to talk about that extensively today, but that's the other side of kind of the investment risk. Do you have sufficiently liquid assets to meet expected and there I say, unexpected cash flows. Alasdair mentioned about the potentially rising rate environment. And that's a good example of an environment that can put stress on your collateral requirements if you have hedging. So to sort of explore that and understand that. And I just want to finish really talking about investment risk. So at the moment, we encourage schemes to look at that. We don't have a one size fits all and how we expect schemes to look at. Sian mentioned scenario analysis. That's something we're very keen on. We encourage schemes to look at that and maybe to look at a couple of different scenarios. We've seen recently concerns about an economic downturn combined with high inflation sort of back to the 1970s, those scenarios are kind of interesting. Typically, in recent past, we've seen economic downturn combined with a fall in inflation, if you look at COVID or if you look at the financial crisis. So I think by looking at different scenarios, it's a great way to kind of sense test your portfolio and see whether it's fit for purpose or if there are improvements that can be made. So with that in mind, I will hand back to Adam. Happy to answer any questions that you might have either now or later.

That's great. Thanks. It's a really good stuff there. I'm surprised we have quite a few questions from the audience. So we've got one here. A usual problem, what happens when the sponsor and the trustee have different views of the end target due to the level of cost? Is the end target mandatory?

Yes. That's a great question. So first of all, we have -- there is a legislative requirement actually in the Pensions Act to set a long-term objective. And the regulations, which will come out reasonably soon from the DWP for consultation, will give you a bit more sort of flesh on the bones of that. But it is expected that, that will cover not only funding but also investment. I suppose the question you could generalize to be, is the same problem that we have today, right, in the sense that sometimes -- not very often, but sometimes employers and trustees can't agree a valuation, and that ultimately does come to the regulator. I mean obviously, we'd expect them to do everything we can to do that. In terms of the investment strategy itself, though, it's very clear under law that, that is owned by the trustees, right, to make changes to the investment strategy. The trustees only have to consult with the employer. So we don't expect that to change in terms of the investment strategy on the sort of here and now. Hopefully, that answers your question.

Great. Thank you, Neil. And so obviously, it's really helpful to hear the regulatory views on risk and how important it is for schemes to have a robust way of measuring this. Sian and Neil both mentioned scenario analysis as an important example. And on this, I'm delighted to say we're launching today, hot off the press, our new online scenario tool, which is freely available to any pension scheme via our website. So after entering a few basic scheme details, this tool will show you the impact on our 5 economic scenarios on your funding level and deficits. So the interest of the impact of [indiscernible], which Neil just mentioned, or the impact of the world finally learning to live with COVID more positive, or the impact of further deglobalization. Then please click on pink scenario analytics box, which should be on the right-hand side, which will take you to the web page. I hope something you can have a look at the end of the seminar. Now on to our next slot, something a little bit different. And before I start this one, I wanted to ask another polling question to the audience. This is about your asset managers, your fund managers. What do you think of the charges you pay your asset manager? Are they too high, about right, too low or don't know? Again, if you can fill out your -- set your answer and press submit. [Voting]

And I'd be quite interested on how people think about this question. Somebody might be thinking about just the headline AMC, that's levied. Somebody might be trying to think about what about all the other extra costs that lie beneath the surface. Perhaps waiting for answers to come in now. A few more moment. There's about quite a lot of people to submit. There we go. There we go, I think that's interesting. So well, firstly, we've got 1% that say it's too low. So may I just say -- may I thank all the asset managers who are in the room for attending today and taking part in our poll. Very much appreciated. But obviously, good chunk about right, which is helpful. But obviously, a lot of people who are too high or actually don't know. But actually, the real question here is how do you properly understand your fund management costs? And more importantly, how would you work out whether you're getting good value for money? And with this I'm going to hand over to Simeon Willis, our Chief Investment Officer, who's going to explore the topic in more detail. Simeon, over to you.

Good afternoon. Yes, I'm going to share some thoughts on how trustees can make better decisions in relation to the cost management within their scheme. This is really important because since October 2020, trustees have been legally required to document their policy in relation to their arrangements with asset managers. This requirement includes how you incentivize and align the manager to medium and long-term strategy, how you evaluate them and how you monitor aspects such as turnover costs. So let's remind ourselves why this is so important. On this chart, I've illustrated the growth of GBP 100 invested 20 years ago in equities. I've deducted different annual costs ranging from between 0.2% and 2% per annum. Whilst these percentage amounts may not sound particularly great, if you're incurring cost of 2% in your portfolio for 20 years, in this example, it leaves you over GBP 100 worth [indiscernible] off than if you'd paid 0.5%. And let's remember, we invested 100% -- GBP 100 initially. So GBP 100 difference at the end is a very substantial erosion of returns. Now of course, it's not quite as simple as this chart suggests. We're making good quality decisions on cost management. We need to make sure we are considering both sides of the equation, the costs we're paying versus the value we're receiving. So let's look at the sources of value that we get from our investment manages. An obvious one is returns. Crudely, you might think higher return equals higher value. However, returns -- some returns are easier to achieve than others. For instance, equity market returns can be achieved at low cost possibly. And last year, the FCA said, it's important to stress that funds will generate positive returns do not necessarily deliver good value. And this was in reference to funds that delivered positive returns for underperformed and appropriate benchmark. Other areas of value include risk reduction. So through diversification or hedging, for instance, currency or liability risks or also managing ESG risks, for example. And we're also benefiting from the expertise of the investment manager, for instance, their discretion to select appropriate levels of risk in different market conditions. So what about the sources of cost? Well, there are several different aspects that are illustrated here. So we've got fund management fees, custody cost, administration, taxes and how do we get information on this cost? You may be familiar with the term OCF, the ongoing charges figure. This captures a range of relatively easily obtainable costs and summarize it as a percentage of the amount invested. It's very similar to what used to be called the total expense ratio. However, whilst it's readily available, the OCF has some notable shortcomings. Here, we illustrate what the OCF includes and what it doesn't. Performance fees don't feature in the OCF, and we'll come on to those in more detail a little bit later. Entry and exit costs are also not included, and they can represent a significant one-off hit to the value of your investment. You can observe these by looking at the bid offer spread of your fund and an entry and exit charges for the fund. And then we've got ongoing transaction costs, perhaps one of the most opaque areas of costs within funds. Now during a recent active global equity review of the market, we found a whole range of different levels of annual turnover of the portfolio, ranging between 20% and 200% per annum. And in some cases, the ongoing trading costs that will be in parting a drag of returns was over 1% per annum. Now the cost associated with this is not often explicitly reported and therefore, it invisibly detracts from the performance of the fund. So how can we get good quality information on the cost base of our investments? The Cost Transparency Initiative was a group founded by the FCA to create a central template for cost information disclosure on funds, and this captures a full range of costs in a comparable format. Experts are undertaking exercises to collect this detailed cost information at scale for all our clients' investments so as to provide a clear picture of all the costs incurred on our clients' portfolios. If you'd like to hear more about this, you can register your interest in the feedback at the end of the webinar. Now coming back to performance fees. Many investors like the idea of performance fees because it aligns the manager with the investor. However, I think the benefit of this alignment is often overplayed as managers are already incentivized to deliver it in order to retain our assets in the long term. If you do employee performance fees, it's absolutely essential to structure them correctly or you could end up paying enormous fees in some circumstances. Modeling plays an important role here in understanding the range of possible outcomes, and we've got an illustration here. So if we had an equity fund and let's say it had a 0.5% fee -- base fee on assets, plus 10% of any positive performance. Here, the manager is potentially earning performance fees just because the market has gone up. And these fees could be unlimited. Signing up to this is literally like writing a blank check. So in this example, the 1 in 10 modeled outcome would involve paying an astronomical fee of 3.7%. And this arrangement could be improved considerably by changing it. So the performance fees are only paid in relation to outperformance above an equity market index. And on top of this, you can include a cap of, say, 5% outperformance. Whilst these done on the surface look that significant, the changes reduced the average fee paid by 1% per year and also means that the performance fee is capped in the event a manager outperforms beyond all expectations. And this does happen. There was one fund, a very well-known fund manager that springs to mind in 2020, who outperformed their equity benchmark by 55%. But performance fees can relate to lots of different arrangements. We've seen a number of cases where fiduciary managers have proposed what, in our view, inappropriate performance fee arrangements, whether you earn extra fees simply because markets go up, which doesn't feel well aligned. We've provided directive advice on this to clients in this situation. Our advice to several clients was to reject a particular fiduciary manager who proposed performance fee and that has saved them over GBP 1.8 million over the last 12 months. And this last piece demonstrates the importance of negotiation, ensuring that your consultant is using their bargaining position to proactively negotiate fees down and pass the savings on to you. This is a fundamental element of our research process at XPS and it's one that we place considerable emphasis on in relation to managing overall fees and costs. So in summary, cost management is something that all pension scheme and trustees legally need to demonstrate they're doing in line with that policy. It's now possible to get good quality cost information, but it's also important to recognize the value that you're receiving so as to avoid false economies from cost cutting. Negotiation also has an important role to play, and your consultants should be making the most of their bargaining power on your behalf like we do at XPS. So on that, I'll hand back to you, Adam.

Great. Thank you, Simeon. I mean what I find that was interesting with these sorts of cost work is actually very small changes and charges applied to a big pound asset value compounded over many years can lead to quite significant savings. Got a question for you, Simeon, if that's okay. If my net returns are okay, do I really care about high costs?

Okay. So if your net returns -- if you're satisfied with your net returns after cost, that's a great start, but it's not necessarily the end of the story because that presumably relates to past performance because we don't know what the performance will be in the future. And managing cost is something that we can actively control that will improve our investment returns going forward. And you don't know how strong those net returns will be in the future because we don't have a crystal ball. So a penny saved is a penny earned, and I think that's an important thing to bear in mind when we're thinking about how to manage costs.

That's great. So we've talked a lot about DB schemes today. And many of the issues we face in these arrangements apply equally to defined contribution schemes. And now going to hand over to Alan Greenlees, who's going to talk about -- the Head of DC Investment, who's going to talk about some of the challenges and interesting developments in the fast-evolving DC market. Alan, over to you.

Thanks, Adam, and good afternoon. I'll start by reflecting back on 2021, which was another really busy year for those managing DC schemes. We saw a really strong year for investment returns, particularly those with more equity buyout strategies and calendar year returns of 20% plus have not been uncommon at all. We've also had a really large number of consultations, many of which are focused on driving forward and improvement in [indiscernible] money and better member outcomes. And it's really that objective around member outcomes that's still at the heart of DC schemes. The long-term front of assets on a net of fee basis remains a core component of value. And the costs, just one part of that value equation, it was really pleasing to see that value is now being assessed more on a net performance aspect rather than a sole focus on schemes. And as Simeon has just discussed as well, schemes should be making every effort to understand what needs to be paid and how that influences value. The flexible time solution to access the low-cost vehicles and members still remains a key topic, and you can't talk about DC without mentioning the growing pace of consolidation in the market. So stakeholders will still remain focused on delivering value to members, especially as 2022 could be more challenging. And with that in mind, I'm going to talk about 3 key areas that I think DC investors could look at to improve those member outcomes. The first one is unlocking illiquidity. Now accessing less liquid instruments, including private markets, has gained a lot of momentum in the last 18 months. But it does feel like we've finally reached a turning point. We have the clear backing from the government bodies that pension themes could and perhaps should be investing in private markets. And a number of those consultations have focused on breaking down these barriers and trying to improve the access, such as allowing for performance fees in the cap. Now the asset managers have also responded by showing innovation in this space, with tailor-made strategies for DC investments. They're starting to view illiquidity as more of a spectrum and a number of these new funds can still provide a premium, but within an open-ended daily price and a platform friendly approach for these seasons. The introduction of the long-term asset funds category, or LTAF, late last year, should also improve the supply funds in the future. Now there's a lot of technical information around the LTAF structure, and they're still a new concept, but it helps to fill a gap in the market. And again, their approach of being an open-ended FCA-authorized but a [indiscernible] product supports the use of private markets and that liquid instruments within DC. Now despite this positivity, I do feel that DC investors still have a bit of an uneasy relationship with a turn in liquidity. It can go against the more traditional view in DC that pension savings need to be very accessible, and members must have the full flexibility to invest how and when they wish. Also the cost of investing in such assets can also be unattractive, particularly if schemes have been wedded to a more traditional and passive way investing beforehand. However, the investment case, we're investing in less liquid assets, I think, is well known. It's already a well-trodden path in DB. And these assets are able to generate strong returns after fees and provide greater diversification to complement listed equities. So there's still a lot of noise around the topic, but illiquid should be something that trustees consider maybe as an addition to equities and how they can improve member outcomes. We move on to sustainability. Now it is difficult to talk about the future of DC without mentioning responsible investing. And Sian earlier set up the risks involved, also the opportunities for investors, and it still remains a critical subject within DC. DC investors typically have a long-term time horizon, maybe 40-years plus, and the strategies tend to be more focused on equities which lends itself really well to a more sustainable approach. There's perhaps also an argument around the generational profile of DC members, with individuals further from retirement often having a stronger preference towards ESG factors and tackling climate change. And there are tools available to capture your member views on ESG, such as member analytics and many schemes are already harnessing that power. And then finally, the wider rollout of the TCFD and the need for schemes to report against sustainable metrics and again, going back to that need for scenario analysis as well. That will support the continued movement and prompt stakeholders to really consider their approach to ESG. But overall, I would like to see the continuation of these descriptions on responsible investing and ideally reflecting the member views, investing sustainably within equities especially becomes a new norm for DC going forward. And then finally, for something slightly different. I wanted to introduce equity protection. Now this is an emerging concept within DC, but one I think is really interesting. I know they'll just have a number of challenges, I'll just focus on the headlines here. Now DC strategies have core allocation to equities to drive performance. Now this is often the case in the accumulation phase, but equities also have a key role in decumulation or the retirement strategies, especially so for members accessing their pension savings through drawdown options, for example. And it's those allocations, which are often the largest contributor to volatility of a member's pension part, and that will be for more a growing concern for those closer to or even in retirement. Now the usual ways of managing that risk have been to reduce the equity exposure entirely, perhaps increase the allocation through [ DTS ]. But an interesting concept is used for equity protection, and this is really to try and limit those downside losses and maybe capping the upside gains to fund that. It's a really complex topic and without a doubt there are several challenges here. But if you are concerned about equity volatility at and through retirement, then this could be one possible solution to our cap. And we are starting to explore this for several schemes already, including quantifying the active risk exposure that we have for their members. We'll potentially have a single fund structure accessible through a platform to manage that active volatility could be a really interesting development in DC. So in summary, I think schemes should continue to focus on the bigger picture of delivering positive member outcomes. And the use of illiquids, sustainable equities and maybe equity protection are just 3 possible solutions to help meet that goal. It would be great to hear your feedback in any of those ideas as I pass back to Adam.

Great. Thanks, Alan. So the 3 DC topics you've raised there, I mean, which one do you think to be the most impactful for members?

I wanted if you might try and pin me down. If I was only picking one, I think sustainability, it needs to be high up on the agenda. The use of sustainable products include sustainable equities with those clear decarbonization targets, for example. It's an area that I feel members understand a lot better now and are wanting to see their investments aligned to those future goals. They all want a good-sized pension part to retire on, I get that, but they also want to have the world around them in which to live in when they do retire. So sustainability still remains really important.

That's great. So we now move on to Q&A session. We've got a good 10 minutes of questions. So please do keep coming them in. We've got quite a question already, and we've got time for quite a few. So I'm going to kick off with one for you, Sian. It says given market conditions, what is the panel's opinion on whether scheme funding levels will grow this year?

That's a good question. And I think in the absence of a crystal ball, I'll try and answer that as best as I can. I think Ali highlighted market volatility to date. I think even just in the first half, first bit of this year first month, anyone with significant global equity exposure might have actually seen a fall in their funding level. But whether that trend will continue, it's probably largely unknown. But I think the main message from Ali's thought was really to expect the unexpected, particularly in growth assets. However, I think for most schemes have already derisked and are actually invested in more income-focused funds, you should have more resilient portfolios to the market turbulence that could be ahead. So for any schemes that potentially are still on this, perhaps don't need to be, certainly worth considering whether -- given the current political climate, now could be a good time to bank those games and derisk and just increase the certainty of your funding level improving over 2022.

Great. Thank you, Sian. And one for you, Ali. Do you think any central banks have or will make a policy mistake, raising rates too early or too late?

That's a good one as well. And yes, I think there's a danger of having a policy mistake. I would say that they are more in danger raising too quickly. I think one thing that concerns me is there's a good piece in the The Economist, global debt has tripled in the last 20 years. And I think global debts are around 330% of GDP. So any rate rises is going to make that debt more difficult to service and potentially a real break on economic growth. So I think the good news is that central banks are pretty measured in what they're doing. They're -- I think certainly the U.K. and the U.S. are going to -- U.S. probably go a bit quicker than the U.K., but I suspect we might not go as quickly as they think because of that, and there's also the other issue like the Ukraine that could damage market sentiment as well. So I think, yes, more of that, I think more the danger of going too soon. So we may not see as bigger as I think that the sort of pricing and rises up to about 1.5% by middle of next year. I wonder if we'll get that far personally.

Thanks, Ali. And can you just expand on the Ukraine point there, a question on that, what impact could the war in Ukraine have on markets?

Yes. Another tough one. I think it will all depend on how contained any conflict is. I mean no one's -- we're all trying to appear in the mind of Putin what is he really after. I think -- let's hope diplomatic efforts went through and we don't see a major conflict. I think as long as it's contained to the region, then the things won't impact to global markets too much. But clearly, there's a risk that things escalate beyond where either party really wants to go. So I think it's another one for that. We'll feel some volatility over the next few weeks and maybe a couple of months. But yes, I'm hopeful that nobody really wants a full-scale conflict on the edge of Europe.

That's great. And a question for you, Neil. When will the new funding code come out?

Yes. So good question and maybe this is the time to thank everybody for their patience for the code. It does seem to have been in the offering for a while. Let me say a couple of things about that. First of all, we are -- there's a bit of a step before the code comes out, so that's an important step and that is the regulations that are owned by the Department for Work and Pensions. They are due to consult on those in the spring of this year. So the regulation is really built on the Pensions Act, which is now a law. And to give you an example, the Pensions Act talks about setting a long-term objective, right? And the regulations will provide a bit more flesh on the bone in terms of that. Once those are being consulted on and complete, then we can issue our second consultation on the code, which kind of provides more of the details that I know people are looking forward to. The current plan is to publish that consultation in late summer. One thing I've learned from working in the civil service or the -- is that summer can last an awful long time. So yes, but the official word is late summer, but a little bit is dependent on those rates coming out for consultation relatively soon.

Great. Thank you. And related point question for you, Neil. I mean how owners would have been perceived to go down the Bespoke route?

Yes. So I think it's worth mentioning on Bespoke. I mean we don't see it as a sort of a bad outcome or sort of a nonoptimal outcome. Both Fast Track and Bespoke are perfectly acceptable ways to comply with the new code. And we will -- we expect to see a few different categories of Bespoke, some people that, for whatever reason, affordability reasons, can't afford to pay the contributions that are due simply because of the problems with the sponsoring employer. But also schemes that, quite frankly, have robust integrated risk management processes that have worked well and served them very well for a period of time, and they want to continue using that and the systems that they've developed. So we might see them going down Bespoke as well. So we do want to make it -- we want to make it clear to people that it's acceptable and -- but we won't shy away from -- as a regulator, Bespoke is departing by definition from that Fast Track regime. And we'll ask people to provide greater evidential rate to that and provide the evidence of that. And if that sort of stacks up, then that's fine. But you can expect the regulator to ask a lot more questions if you're going down the Bespoke route.

Great. And a question for you, which you probably have asked many times before, why are you forcing people to invest in gilts?

Okay. Well, thank you for that. Yes, I mean, as a regulator, you grow a thick skin to lots of your questions there. So I think that is a valid challenge. I mean I think it's right to say that we're not forcing anybody to do anything. We are encouraging people to measure their risk in an appropriate way. And many, many schemes do this already, right? But unfortunately, some don't. And I do think that places their members at risk. So measured investment risk is important. For some schemes, when they look at their employer, strength of their employer and their maturity, they'll find that the risk there running is fine. A very small number of schemes will be running at an inappropriate level of risk, and we don't shy away from calling that out and focusing on that in the code. But there are various ways to deal with that, and it's not just a question of plowing into gilts. So for example, schemes that want to maintain quite a high level of risk in their investment strategy, higher than we'd accept in Fast Track. If they have a contingent asset or an escrow arrangement or some other way of providing downside protection to the scheme, then that's fine, we'll look at that in a very reasonable way. The other thing that's worth mentioning is that if you tracked, I think Sian mentioned the Purple Book, the PPF Purple Book, that looks at the asset allocations of schemes. And you can see that's been moving steadily towards bonds for a very long period of time now. So much so that 72% of schemes, if you weigh them by size, have an allocation to bonds already. So I think schemes are already moving on this journey even before the code is in place. And the motivation of the code is really to not change necessarily where your average scheme is or your well-run scheme, but it is very much to focus on some of those schemes that are real outliers and pose a risk to the members. And that's we think the investment risk and the way it looks, that will really help us.

Great. Ali, a quick question for you. Do you think equity protection will become mainstream point of DC schemes?

It's my turn [indiscernible]. I think at this point in time, it is far too early to see this being introduced in the mainstream solution within default. I do think it's a really interesting solution to a quite a complex problem. There's plenty of nuances to it. But certainly, for investors where actually volatility is a key concern, this could be something to look at. So we need to work through those challenges first to understand how and where member outcomes are improved, but it's definitely one for the future.

That's great. And Sian, one question for you. Are many ESG investments overpriced due demand for ESG investments? And does that mean passive index investing ESG is likely to generate below market returns?

Yes. Well, I think the direction of travel into sort of ESG funds isn't something that's going to reverse anytime soon. And so any sort of premium or as they call it, the greenium, being paid, it's really unlikely to cause you concern in the long run. I think demand will continue. And in terms of sort of the passively invested ESG indices, I actually would argue that recent evidence has actually shown the opposite of that. We've now seen the MSCI ESG Index outperformed its parent index for the second year in a row now. And the FTSE4Good has outperformed the FTSE All-Share over the last 10 years. So I don't think it's detrimental necessarily to passively invest in ESG indices.

Thank you. I'm afraid it's almost 4:00, and as I need to wrap up today's webinar, I'm very sorry we didn't get to your question, but we will respond via e-mail. I mean thank you all again for your time today. I know I'll be taking a number of key messages. We started with Sian and Ali, expect the unexpected in 2022, there is no [ text to tell ] schemes how to respond to the current challenges. But we are worried about certain risk exposures, there are things you can do with your investments. We heard from Neil, the regulator, that risk assessment is vital, and the funding changes are coming. [indiscernible] companies should start thinking about the impact of the new code on the schemes sooner rather later. Simeon touched on the important work of assessing costs and making sure you're getting the best value possible. Here, small changes can have a really big impact when compounded over many years. And finally, with Alan, there were a number of new exciting developments in DC space that can go a long way to helping improve member outcomes. Just before you go, don't forget to download your CPD certificate at the end by using the CPD button. A feedback form will pop up at the end of the webinar, we will be grateful if you could take time to fill out. And finally, I just like to give thanks to our 4 XPS speakers and extra thanks to our special guest, Neil Bull. The next XPS live event is on the 17th of March for DC schemes entitled '21 The Year to Decide To Govern or Consolidate? Have a great rest of the afternoon, and we hope to see you very soon. Thank you.