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Asset breakdown

Note: This updated guidance has been published for the 2024 DB and Hybrid scheme return window to give sight of updates to the guidance.

The asset breakdown section captures information about a scheme’s investment risk. We assess this information in the context of the maturity of the scheme’s liabilities and the strength of the employer covenant. This information is also used in the calculation of the PPF levy.

Tier allocation based on s179 valuation page

Which tier does this scheme fall into based on total scheme liabilities recorded in the last s179 valuation?

The answer provided here will determine the minimum level of information you will need to enter in the rest of this section. You can choose to trade up and provide more information on the next page.

The tier ranges relate to the total protected liabilities in the last s179 valuation. The total protected liabilities should include estimated costs of wind-up, estimated expenses of benefit installation / payment and any external liabilities.

  • Tier 1(Simplified) — less than £30 million 
  • Tier 2 (Standard) — £30 million to less than £1.5 billion
  • Tier 3 (Enhanced) — £1.5 billion or more

Trade up options page

Would you like to trade up and provide more information about this scheme’s asset breakdown?

Submitting more information helps TPR assess a scheme’s investment risk more accurately and provides the PPF with more detailed information to calculate a scheme’s PPF levy invoice. Schemes with highly diversified growth assets or significant hedging programmes, for example, LDI (liability-driven investments), may wish to trade up so their investment risk can be better reflected.

You do not need to stay in the tier you choose to move to this year in future scheme returns. Similarly, if you chose to trade up last year you do not have to do so this year. You can also change tier if you add a new asset breakdown outside of the scheme return window.

  • No, I do not wish to trade up 
  • Yes, I’d like to trade up to Tier 2

Select this option to enter the following information in the rest of this section:

  • Additional asset categories

Investment in absolute return funds

Investment in private debt

  • Bonds breakdown

Investment grade bonds split into UK and Overseas holdings

Maturity of any bonds held (short, medium and long)

  • Equities breakdown

Overseas equities split into developed and emerging market holdings

  • Yes, I’d like to trade up to Tier 3

Select this option to provide all of the Tier 2 information, as well as any risk factor stress impacts where the exposure of the underlying holdings is not reflected in the asset breakdown for:

  • Equities (UK)
  • Equities (non-UK Developed)
  • Equities (Emerging)
  • Interest rate
  • Inflation
  • Credit

These items capture movements in the value of derivative holdings under specified scenarios. The risk factor stresses page contains guidance on how to carry out the calculations.

We encourage schemes to report as much of their exposure as possible through the asset breakdown. Only submit risk factor stress impacts for particularly complex holdings whose exposures cannot be easily reflected in the asset breakdown.

Asset allocation page

The asset allocation you enter should reflect the economic characteristics of the scheme's investments as closely as possible. The aim should be to capture information which will allow the PPF and TPR to assess the levels of volatility in assets relative to liabilities. We accept that reflecting exposures shown in the asset breakdown may be difficult. Asset exposures should be reasonably accurate, but approximations are acceptable where the impact is not significant.

How to complete this section:

  • Read the guidance provided.
  • Talk to the scheme's investment adviser or asset managers if you’re unsure how to allocate the scheme's investments.
  • Take asset allocations from the scheme’s most recently audited accounts.
  • All percentages can be accurate to a maximum of two decimal places.
  • The sum of the asset breakdown items must equal 100%.

General guidance

If the scheme’s most recent accounts do not include asset information required

Schemes should make a reasonable effort to complete the asset breakdown as accurately as possible. We understand that some schemes may not have the required level of detail from their latest audited accounts date, particularly if the accounts date is not recent.

You should attempt to get the more detailed information from the scheme’s investment managers or consultants. However, we recognise that for some schemes the cost of gathering this information may become disproportionate. In this case, you should complete the asset breakdown as accurately as possible with the existing asset information.

For future years, schemes should consider whether to update the asset allocation in the annual accounts in line with the updated information requirements.

How to allocate liability-driven investment allocations (LDIs)

Liability-driven investment funds come in a variety of forms. When submitting the asset breakdown, the key principle should be to reflect the economic characteristics of the investments into the available asset categories.

A feature of some LDI positions is that they use leverage. This means that the capital invested is used to provide greater exposure to gilt yield movements than would be possible with unleveraged assets (such as physical gilts).

Trustees should seek advice from their investment advisor or LDI manager as to how they classify LDI funds. Some examples for the treatment of leveraged LDI positions are given below. The percentage figures are proportions of the total LDI allocation within the LDI position, rather than of the total value of assets in the scheme.

 LDI position Description of the underlying investments Asset category allocation
Real interest rates leveraged LDI

Position leveraged to provide 1.9 times.

Underlying assets could be gilts, index-linked gilts, interest rate swaps, inflation swaps, and gilt repos.

+190% UK inflation linked government bonds

–90% cash and net current assets

Nominal interest rates leveraged LDI

Position leveraged to provide 1.8 times exposure.

Underlying assets could be gilts, interest rate swaps, and gilt repos. 

+180% fixed interest UK government bonds

–80% cash and net current assets.

Equity linked LDI Example 1 75% gilts, 25% cash, and 100% long UK equity futures.

75% fixed interest UK government bonds

100% UK equities

–75% cash and net current assets.

Equity linked LDI Example 2 +100% global equity exposure (5% UK) with 200% long duration sterling real interest rates exposure.

 200% UK inflation linked bonds

+95% overseas equities

+5% UK equities

–200% cash and net current assets. 

Diversified growth LDI position

Position leveraged to provide 1.8 times exposure.


120% long-term real sterling interest rates with 60% underlying unconstrained DGF exposure.

120% UK inflation linked government bonds

+60% absolute return fund

–80% cash and net current assets.

Credit backed LDI 100% credit default swaps (CDS) and 100% long duration real interest rates.

100% UK inflation linked government bonds

+100% Fixed interest — UK investment-grade (excluding UK government)

–100% fixed interest UK government bonds.

This is a complex area, and trustees should seek advice from their investment advisor and or asset managers on how best to classify their investments. 

How to allocate multi-asset funds

What is a multi-asset fund?

Multi-asset funds typically offer investors an allocation to a number of asset classes in a single fund.

They include, but are not limited to, the following:

  • diversified growth funds (DGF)
  • absolute return funds
  • managed/balanced funds
  • insurance funds
  • global aggregate bond portfolios
  • emerging market portfolios combining debt and equity
  • multi-asset credit funds
  • private market funds combining corporate debt and equity and/or property/infrastructure assets
  • hedge funds

How to allocate multi-asset funds:

You can take one of the following approaches depending on the characteristics of the fund:

  • Allocate 10% to the DGF asset category (all Tiers).
  • Allocate to the absolute return funds asset category (available for Tiers 2 and 3).
  • Get a breakdown of the underlying asset classes and allocate to the available asset categories.
  • Allocate to the ‘Other’ asset category.

Read the guidance for DGFs, absolute return funds (Tiers 2 and 3 only) and ‘Other’ to help you decide on the most appropriate approach to take. 

Schemes have full discretion to get a detailed breakdown of the underlying assets in the multi-asset fund and allocate accordingly. Keep in mind that if a fund generates returns regardless of market movements (for example, a long-short absolute return fund), then splitting the fund by asset categories is not a suitable way of capturing the level of risk.

Example

A pension fund has 10% of its assets in an emerging markets fund which includes 40% in emerging market bonds and 60% in emerging markets equities. There are potentially two approaches:

  1. Allocate 10% to the DGF asset category (available for all Tiers).
  2. Allocate 6% to the emerging market equity allocation and 4% to overseas bonds (available for Tiers 2 and 3).

Using option 2 would require more data from the asset manager. Trustees and advisers should consider whether the costs of getting this data are proportionate.

In contrast, a global bond fund should be categorised under a more granular approach (unless it is an absolute return bond fund).

For example, a global bond fund with 60% in corporate bonds and 40% in government bonds should be allocated to the various bond categories.

Allocating assets where a breakdown is not reported

If there isn't a breakdown of assets detailed in your audited accounts, then you have two options:

  1. Contact the scheme's investment manager to get a split of assets at the accounting date.
  2. Where the cost of option 1 is disproportionate, get a split of assets from the investment manager's report nearest to the accounting date. For example, if your accounting date is 5 April and you have the split at 31 March from your regular monitoring of investments, you should enter the split at 31 March as an approximation for the split at 5 April.

Allocating assets where they could be classified in multiple categories

For some investments, the most appropriate asset category may depend on the way the pension scheme has invested.

Where this isn't clear, we suggest that trustees consult their investment manager or investment adviser.

We have provided more information on three common areas where asset classification may be difficult below.

Infrastructure

Investment in infrastructure is widely accessed via private equity-type vehicles and should in these circumstances be classified as 'Unquoted equities / private equity' assets. However, some infrastructure investments are debt instruments. Where this is the case, the characteristics would be more like that of a corporate bond. That means that the investment should be classified as fixed interest investment grade, sub-investment grade or private debt in the scheme return. See the guidance under the relevant bond categories for more information.

Structured equity products

Structured equity products can be made up of cash, bonds and equity derivatives. We expect the advice of investment professionals to be taken in deciding whether, given their risk characteristics, such investments can be appropriately allocated between the asset categories available in the scheme return. If the exposure of these instruments cannot be adequately captured in the asset breakdown, the scheme could consider trading up to Tier 3 to provide information about risk factor stress impacts.

If the cost of seeking this clarification or of calculating risk factor stress impacts is disproportionate, the value should be classified as 'Other'.

If allocating between asset classes, aim to capture the exposure to movements in the underlying markets.

Examples

In these examples, the general theme is that the total value of the structured equity product is known from the accounts. The value to assign to equities is the notional value (not the market value) of the derivatives at the accounting date, suitably delta-adjusted where the delta of the derivative is not 1. A pragmatic estimate of deltas is acceptable. The difference in value between the delta-adjusted notional exposure of the derivatives and the overall value of the structured equity product is made up of any physical assets and cash, i.e., delta-adjusted exposure of derivatives + value of physical assets + cash = total value of structured equity product

The cash will be a balancing item.

Example 1

A structured equity product includes several European call options, many of which are in the money and no other assets that provide market exposure. The overall delta of the portfolio of call options is 0.6, so the exposure to equities from these equity options is taken to be 0.6 x the notional exposure (delta is the sensitivity of the call options to movements in the underlying equity markets). In a downward stress the delta of these call options reduces, so the exposure to equities from these equity options may be reduced to allow for the average delta in a downward stress of around 20% – for example, it may be estimated to be 0.5 x the notional exposure. Let’s call this the delta-adjusted notional exposure. If the structured equity product includes no other derivatives, then this delta-adjusted notional exposure should be entered in the appropriate equity category or categories, depending on the type of equities on which the options are based.

The total value of the structured equity product should be available at the date of the audited accounts and a cash value can be entered such that cash value + delta-adjusted notional exposure = value of structured equity product.

Example 2

The structured equity product also includes some short equity futures. These should be included as a positive cash position and a negative value for the equities equal to the notional value of the futures indexed from their date of inception to the accounting date, the sum of which is the market value of the futures (which may be positive or negative).

The notional value of all equity derivatives (delta-adjusted, wherever the delta is not 1), can be entered as equities and then a cash value can be determined at the end of this process to make up the difference between this delta-adjusted notional value and the total market value of the structured equity product.

Convertible bonds

The classification of some investments, such as convertible bonds, may depend on financial market conditions.

For example, it might be appropriate to classify a portfolio of convertible bonds either as equity investments or as corporate bond investments. If the conversion option represents a high proportion of the overall asset value (generally when the underlying share price is high), then the convertibles are likely to be highly sensitive to the value of the underlying shares – so classification to the relevant equity asset class ('UK quoted equities' or 'Overseas quoted equities') is likely to be most appropriate. On the other hand, if the conversion option represents a small proportion of the overall asset value (generally when the underlying share price is low), then the convertibles are likely to behave more like corporate bonds – so classification in an appropriate non-government bond category is most appropriate.

In these types of cases, schemes should consult their investment advisor or asset managers to understand the most appropriate category in the context of current market conditions.

Asset valuation date: [DD] [MM ] [YYYY]

Asset categories:

Bonds %

If you enter a percentage here, you must complete ‘Bond categories’ on the following screen.

Equities %

If you enter a percentage here, you must complete ‘Equity categories’ on the following screen.

Property %

Guidance on property

Assets that should be captured here include:

  • all UK and overseas land or property (commercial, residential and industrial)
  • any land or property owned by the pension scheme that is occupied by a scheme sponsor
  • holdings in non-listed property funds (for example, property unit trusts)

Listed property funds such as Real Estate Investment Trusts (REITS) may be included here where the holding is explicitly intended to provide exposure to the property sector. However, small concentrations of these held as part of a larger equity portfolio do not need to be separately identified and can be included along with the rest of the portfolio as UK or overseas quoted equities.

Deferred or immediate fully insured annuities %

Guidance on deferred or immediate fully insured annuities

Insured annuities are contracts through which payments in respect of a portion of the scheme’s liabilities are met by a third-party insurance company. Typically, such contracts will be written in the name of the pension scheme trustees. These annuities relate to a particular group of named members or dependants of the scheme.

Assets that can be allocated to this category:

Include the proportion of total assets invested in annuities where the audited accounts reflect a value for these assets. 

If annuity assets (and matching liabilities) are excluded from the scheme accounts, then the asset breakdown in the scheme return should not include these assets either. 

Diversified growth funds (DGFs) %

Guidance on diversified growth funds

Read the guidance on multi-asset funds before deciding whether to allocate to this category.

A diversified growth fund (DGF) invests across a range of asset classes with the aim of generating growth with lower volatility than equities.

DGFs have a volatility (risk) target. Typically, this is expressed in relation to equity markets, often within the range 1/3 to 2/3 of equity market volatility.

The difference between DGFs and absolute returns funds is that DGFs generate growth which is sensitive to movements in typical major asset classes (beta). This may be through a mix of direct holdings and investments in other funds (both internal and external), although it may also be achieved using derivatives. In contrast, absolute return funds predominately use derivative-based strategies to reduce performance sensitivity to the typical major asset classes. Look at the guidance on absolute return funds (Tiers 2 and 3 only) for more information.

Cash and net current assets %

Guidance on cash and net current assets

Cash investments have high liquidity and short maturities (usually 90 days or less).

Include in this category:

  • Cash in any currency or denomination
  • Cash held in savings accounts, bank accounts, money market funds, negotiable certificates of deposit (CDs), commercial paper and floating rate notes (FRNs)
  • Net current assets

Absolute return funds % (Tiers 2 and 3)

Guidance on absolute return funds

Read the guidance on multi-asset funds before deciding whether to allocate to this category.

Absolute return funds aim to provide a positive absolute return over the medium to long term irrespective of market conditions, while reducing the risk of losses. By taking this approach, these funds meaningfully reduce performance sensitivity to the typical, major asset classes, such as equities, over the longer term. This provides downside protection during periods of market stress.

This lower sensitivity is likely to be achieved by significant use of derivative-based strategies that will permit offsetting positions to be taken against markets.

Any absolute return funds that have a benchmark or outperformance target above cash plus 5% or above inflation plus 5% should not be allocated to the absolute return fund category and should instead be allocated to ‘Other’.

Asset-backed contributions (ABCs) %

Guidance on asset-backed contributions (ABCs)

An asset-backed contribution arrangement (ABC) is a contractual arrangement between trustees and one or more entities within the sponsoring employer’s group. ABCs involve regular payments to the scheme for the duration of the arrangement, often being indirectly funded by the sponsoring employer. Such payments are underpinned by an asset.

The PPF collects additional information about ABC arrangements to feed into their levy calculation. The actual s179 ABC amount submitted by 31 March each year will be used to reduce the value of assets in the scheme’s levy calculation. To obtain levy credit for an ABC, the trustee must certify the ABC value and ABC payments annually by 31 March. You can do this by completing the online form on the PPF’s website (opens in new tab).

Without submission of this information, the PPF may take information from the scheme return or may make conservative assumptions. This would mean that schemes may not gain appropriate credit for the ABC (or the coupons paid from it) in their levy calculation and the deduction the PPF makes from the scheme assets to calculate the levy may not be fully accurate.

Other %

Guidance on Other

Some assets do not obviously fall into any of the available categories.

A general description of the key characteristics of each asset category has been provided so that in such circumstances, the trustees, in conjunction with their investment advisor or asset manager, can apply judgement as to which category best reflects that asset’s risk characteristics – this may involve dividing the asset amongst more than one category.

Only if assets cannot be assigned in this way, should they be recorded as 'Other'.

Examples of assets that could be included here are:

  • hedge funds that cannot be included as absolute return funds or split up into constituent parts
  • insurance funds that cannot be split up into constituent parts
  • commodities

Bonds category breakdown page

You’ve told us that bonds are held and/or that the scheme has exposure to interest rates, inflation or credit. Indicate the percentage split over the following categories. Your entries must add up to 100%.

Fixed interest — UK government bonds % 

Guidance on fixed interest — UK government bonds

Include in this category UK government bonds (gilts) and other bonds with explicit UK government guarantees, for example, supranationals with UK government guarantees.                  

Fixed interest: investment grade % (excluding UK government) (Tier 1 only)

Guidance on fixed interest — investment grade (excluding UK government)

Note: Although this is a fixed-interest category, inflation-linked public corporate bonds and inflation-linked overseas government bonds should also be included here.

Include bonds (except UK gilts) with investment grade credit ratings where investment grade is defined as a credit rating of at least BBB (Standard and Poor’s / Fitch) or Baa (Moody’s).

Examples of these are:  

  • UK corporate bonds
  • overseas government and corporate bonds
  • UK and overseas debt-like investments
  • convertible bonds where they are classified as debt-like
  • asset-backed securities (ABS)
  • mortgage-backed securities (MBS)
  • sterling inflation-linked corporate bonds
  • inflation-linked bonds issued by overseas governments or corporates – for example, Treasury Inflation-Protected Securities (TIPS)
  • senior debt with an investment grade rating which forms part of structured credit
  • supranationals and other sub-sovereigns (for example, bonds issued by supranational agencies) where there is no UK government guarantee

Fixed interest — UK investment-grade public corporate and other public debt % (excluding UK government) (Tiers 2 and 3)

Guidance on fixed interest — UK investment-grade public corporate and other public debt

Note: Although this is a fixed-interest category, UK inflation-linked public corporate bonds should also be included here.

For Tiers 2 and 3, private debt has its own asset category. Tier 1 private debt should be included in ‘Fixed interest—sub-investment grade’.

Include sterling-denominated UK public corporate bonds and debt-like investments with investment grade credit ratings where investment grade is defined as a credit rating of at least BBB (Standard and Poor’s / Fitch) or Baa (Moody’s). 

Examples of these are:       

  • convertible bonds where they are classified as debt-like
  • asset-backed securities (ABS)
  • mortgage-backed securities (MBS)
  • sterling inflation-linked corporate bonds
  • senior debt

Fixed interest — overseas investment-grade public corporate and other public debt % (including overseas government) (Tiers 2 and 3)

Guidance on fixed interest — overseas investment-grade public corporate and other public debt

Note: Although this if a fixed-interest category, overseas inflation-linked public corporate and other public bonds, as well as inflation-linked overseas government bonds, should also be included here.

For Tiers 2 and 3, private debt has its own asset category. Tier 1 private debt should be included in ‘Fixed interest—sub-investment grade’.

Include overseas government and non-sterling-denominated public corporate bonds and debt-like investments with investment grade credit ratings where investment grade is defined as a credit rating of at least BBB (Standard and Poor’s / Fitch) or Baa (Moody’s).

Examples of these are:

  • overseas debt-like investments
  • convertible bonds where they are classified as debt-like
  • asset-backed securities (ABS)
  • mortgage-backed securities (MBS)
  • senior debt
  • bonds issued by supranational agencies
  • inflation-linked bonds issued by overseas governments or corporates – for example, Treasury Inflation-Protected Securities (TIPS)

Include assets here even if the underlying bonds are currency hedged into sterling.

Fixed interest — sub-investment-grade % 

Guidance on fixed interest — sub-investment-grade

Tier 1 schemes should include private debt in this category.

Include UK and overseas corporate and government bonds and debt-like investments with below investment grade credit ratings where investment grade is defined as a credit rating of at least BBB (Standard and Poor’s / Fitch) or Baa (Moody’s). 

Example of these are:

  • high yield bonds
  • distressed debt
  • subordinated debt
  • mezzanine debt
  • leveraged loans

Private debt % (Tiers 2 and 3)

Guidance on private debt

Private credit is an asset defined by non-bank lending where the debt is not issued or traded on the public markets. Private credit can also be referred to as 'direct lending' or 'private lending'. Private debt is tailored to the borrower’s specific needs.

Private debt differs in terms of where it stands in the capital structure of a company. Include all types of private debt from senior debt, mezzanine debt, distressed debt and asset-backed debt.

UK inflation-linked government % 

Guidance UK inflation-linked government

Include:

  • UK government inflation-linked bonds (index-linked gilts)
  • Inflation-linked bonds with explicit UK government guarantees 

Bonds maturity breakdown page (Tiers 2 and 3)

You’ve told us that bonds are held in the following categories for the scheme. Indicate the percentage split by maturity. Entries for each set must add up to 100%.

Where it’s not possible to get the full maturity breakdown, allocate assets to the category that best represents the overall economic exposure.

Fixed Interest — UK government bonds and UK inflation-linked government bonds:

Short (less than 5 years) %

Medium (5 to 15 years) %

Long (more than 15 years) %

Fixed interest — overseas investment grade public corporate and other public debt and Fixed interest — UK investment grade public corporate and other public debt:

Short and medium (less than 10 years) %

Long (10 years or more) %

Equities category breakdown page

You’ve indicated that equities are held. Indicate the percentage split over the following categories. Your entries must add up to 100%. Schemes should try to provide a breakdown between the categories, where possible.

We use the MSCI Global Equity Indices categorisations (opens in new tab) to distinguish between overseas developed and emerging markets. Include both emerging markets and frontier markets from the MSCI classification within the emerging markets category. You can search the MSCI website to confirm the list of countries that currently have this categorisation.

UK quoted %

Guidance on UK quoted

Include:

  • all equity investments where the underlying shares are quoted on the London Stock Exchange or Alternative Investment Market (AIM) unless those shares are denominated in currencies other than sterling.

Convertible bonds 

This category may also include convertible bonds where they are classified as equity-like.

In these types of cases, schemes should consult their asset manager or investment adviser to understand the most appropriate category in the context of current market conditions.

Overseas quoted %

Guidance on overseas quoted

Include all equity investments where the underlying investments are quoted on the stock exchanges of (non-UK) markets or which are not denominated in sterling. 

Developed market % (Tiers 2 and 3)

Guidance on developed market

Include all equity investments where the underlying investments are quoted on the stock exchanges of developed markets, or which are denominated in the currencies of those developed markets.

Exclude equities that are denominated in the currencies of emerging markets.

Emerging market % (Tiers 2 and 3)

Guidance on emerging market 

Include all equity investments where the underlying investments are quoted on the stock exchanges of emerging markets or which are denominated in the currencies of those emerging markets.

Unquoted equities/private equity %

Guidance on unquoted equities/private equity

Unquoted equities/private equity represent investments in the equity capital of unlisted companies or investment structures. Equity capital is a form of investment in which the investor shares in the profits of the company or structure but is exposed to the first loss on capital.

Assets that can be allocated to this category:

  • UK and overseas unquoted equity shares
  • private equity
  • venture capital
  • leveraged buy-outs

Risk factor stresses page (Tier 3)

We encourage schemes to submit as much of their exposure as possible through the asset breakdown. Only submit risk factor stress impacts where there are particularly complex holdings whose exposures cannot be easily reflected in the asset breakdown.

The scheme's investment manager or consultant will be able to supply this information where it’s required.

Enter the exposures of any relevant derivatives (as calculated using the below guidance) based on information in the most recently available audited scheme accounts multiplied by the risk factor stress percentages set out in the PPF levy rules for the appropriate levy year (opens in new tab)

Note that relevant derivatives are those whose exposures have not been included in the allocations provided (to avoid double-counting the impact of those derivatives).

Read the guidance provided. Ensure that the correct sign (positive or negative) stress factor is used in the calculations.

Guidance on reporting options where the relevant exposures are fully reflected in the asset breakdown

Where the relevant exposures are fully reflected in the asset breakdown, the corresponding risk factor stress impacts should be entered as zero (rather than being left blank).

For example, for a scheme which holds all its assets in a 2x leveraged nominal LDI fund, the reporting options would be:

Reporting option Bond allocation Cash allocation Interest risk factor stress Impact
Option 1 – recommended 200% –100% Zero
Option 2 Physical bond allocation (between 0% and 100%) Physical cash allocation (between 0% and 100%) Based on the synthetic component of the LDI fund
Option 3 0% 100% Based on the full exposure of the LDI fund

Equities (UK) £

Equities (non-UK Developed) £

Equities (Emerging) £

Calculations for equity derivative strategies

Types of equity derivative strategies

An equity derivative strategy is where a scheme enters into a contract with another party to pay or receive a series of payments (or one single payment) whose amounts are determined by the future movement of equity markets.

Example equity derivative strategies:

  • Equity futures or forward contracts: these contracts promise to pay the holder the return on an equity index (for example, FTSE 100, or S&P 500) or an individual share.
  • Equity total return swaps: these contracts promise to pay the contract holder the total return on an equity index (for example, FTSE 100 or S&P 500) in return for a series of payments from the contract holder to the counterparty.
  • Equity options: these contracts give the buyer the right, but not the obligation, to buy (or sell) some equities at a particular strike price. These contracts are typically used to protect the scheme from equity markets falling below a certain level, in return for paying an upfront premium (for example, a “put option” or “put spread”). In some cases, schemes may also have agreed to limit their gain from rising equity markets, in return for receiving an upfront premium (for example, a “call option” or “call spread”). Most other commonly used option strategies are typically combinations of buying or selling put or call options (for example, a “put collar”).

Instructions for calculating equity derivative stresses

Equity futures and forwards:

The risk factor for an equity futures position is based on the notional exposure of the futures position.

Notional exposure is defined as the economic exposure of the position at the date of inception, adjusted in line with the relevant equity index return from the date of inception to the calculation date (the date of the latest audited accounts).

If a scheme holds:

  • a long position – the notional exposure should be positive
  • a short position – the notional exposure should be negative

Equity forward contracts and equity total return swaps can be valued in a similar way to equity futures.

Equity total return swaps:

If the scheme is receiving the equity total return, then the notional is positive and if it is paying the equity total return leg, then it is negative.  Again, notionals are indexed from the date of inception to the date of the latest audited accounts.

Equity options:

The stress on the equity option is the change in the intrinsic value of the option as a result of applying the appropriate stress to the underlying equity index. The calculation is set out below and should be carried out separately for each option that the scheme has.

Input parameters:

Calculation date

Effective date of the most recently available audited scheme accounts

Strike index level of option

S

Level of the underlying index at the calculation date

P

Notional option exposure at the calculation date

E

Equity risk factor stress

d_equity

Notional exposure is defined as the economic exposure of the position at the date of inception, adjusted in line with the relevant equity index return from the date of inception to the calculation date.

Calculation of equity option exposures

The purpose of this calculation is to determine an exposure to which the equity factor stress can be applied. It is a simplified method which ignores time value and considers changes in intrinsic values.  It is not prescriptive – more accurate methods are also acceptable.

A. Equity put option

  1. Calculate stressed level of index

P_stress = P × (1 + d_equity)

  1. Calculate baseline level for valuing option

Baseline_put = min [P, S]

  1. Calculate stress applied to exposure

Exposure_stress_put = min [0, (P_Stress – Baseline_put) ÷ P]

  1. Calculate proportion of stress to apply

Exposure_proportion_put  = Exposure_stress_put ÷ d_equity

  1. Calculate adjusted exposure

Exposure_applicable = Exposure_proportion_put * E

B. Equity call option

  1. Calculate stressed level of index

P_stress = P × (1 + d_equity)

  1. Calculate baseline level for valuing option

Baseline_call = max [P_stress, S]

  1. Calculate stress applied to exposure

Exposure_stress_call = min [0, (Baseline_call – P) ÷ P]

  1. Calculate proportion of stress to apply

Exposure_proportion_call  = Exposure_stress_call ÷ d_equity

  1. Calculate adjusted exposure

Exposure_applicable= Exposure_proportion_call * E

The Exposure_applicable should be added to the total exposure for equity if the scheme:

  • bought a call option
  • sold a put option

The Exposure_applicable should be subtracted from the total exposure for equity if the scheme has:

  • bought a put option
  • sold a call option (we would expect this to be an unusual position for a pension scheme to take unless in combination with other equity options that are bought)

Total exposure calculation

Example - Overseas developed equity derivatives calculation

Total exposure =

(overseas developed equity futures notional exposure

+ overseas developed equity forwards notional exposure

+ overseas developed equity total return swaps notional exposure

+ overseas developed equities Exposure_applicable (for equity options)).

The relevant equity risk factor stress impact should be the total exposure multiplied by the relevant equity risk factor stress (the relevant d_equity, including the sign of the d_equity).

This calculation can be repeated for UK equities and emerging market equities.

Interest rate £

Calculations for interest rate derivative strategies

An interest rate derivative strategy is where a scheme enters a contract with another party to pay or receive a series of payments (or one single payment) whose amounts are determined by the future movement of interest rates. They are a common component of ‘LDI’ investment strategies. They typically consist of interest rate swaps and protect the scheme’s funding level volatility from interest rate movements. Some schemes may enter these contracts directly with counterparties, or they can be done through pooled funds – often called ‘LDI pooled funds’.

Pension funds in the UK may use a range of interest rate derivatives, either in segregated or pooled fund format. These may include swaps contracts, gilt repos, gilt futures, gilt total return swaps or interest rate swaption strategies.

Where a derivative contract is reflected in the interest rate risk factor stress impact, the stress calculation quantifies the change in the value of the derivative contract associated with the interest rate risk factor stress. The interest rate stress factor impact entered should capture the impact across all derivative exposures you choose to include in the interest risk factor stress.

Swaps contracts

Swaps contracts are between two parties – in the simplest version of a swap, one pays a floating interest rate, the other pays a fixed interest rate. It is most typical for pension funds (or pooled funds on their behalf) to enter contracts where they are receiving a fixed interest rate from the counterparty (and hence paying the floating interest rate).

Gilt derivatives

Gilt derivatives include gilt repos, gilt futures and gilt total return swaps. Derivatives of bonds issued by supranational organisations may also be included here, provided that the supras have explicit UK government guarantees. Pension schemes may hold these instruments to give them synthetic exposure to the underlying gilts. The calculation of the exposure is similar to that for swaps. We would generally expect pension schemes to be the holders of the side of these contracts that gives them positive exposure to long-dated cashflows.

The required exposure for gilts and swaps is the total PV01 of the portfolio.

This can be obtained from the asset manager. This is the sensitivity of the portfolio value to a one basis point (or 0.01%) increase in interest rates.

We expect that the PV01 will generally be a negative value, giving a positive risk factor stress impact when multiplied by the negative interest stress factor.

Negative interest risk factor stress impacts may occur, for example if the relevant exposures are predominantly short. We would expect these situations to reflect short-term tactical decisions rather than long-term funding strategy.

The interest risk factor stress impact in respect of each derivative will be the value of each PV01 x the sign and number of basis points corresponding to the interest rate risk factor stress.

Important note: avoid double counting derivative asset exposures.

PV01 is the £ change in value for a 0.01% increase in interest rates across the whole curve. The corresponding risk factor stress impact entered here should exclude any synthetic exposures which have been included as physical bonds in the Tier 2 asset allocation section.

For example, for a scheme holding 30% of assets in a 2x leveraged nominal LDI fund, 70% of assets in an equity fund, and no other assets:

  • If the bond exposure has been entered as 60% of scheme assets (alongside – 30% cash) then the interest rate risk factor stress impact in respect of this position should be nil.
  • If the bond exposure has been entered as 0% (alongside 30% cash) then the interest rate risk factor stress impact in respect of this position should be the full PV01 of the LDI investment multiplied by the sign and number of basis points corresponding to the interest rate risk factor stress.
  • If the bond exposure has been entered as the physical bond allocation (between 0% and 30%) then the interest rate risk factor stress impact in respect of this position should be the PV01 of the synthetic component of the LDI investment (i.e., any PV01 from derivative contracts such as swaps or gilt repos) multiplied by the sign and number of basis points corresponding to the interest rate risk factor stress).

Swaptions contracts

Interest rate swaptions are options to enter into a swaps contract at some defined point in the future. A pension fund can either be the buyer or seller of the option and can be either paying or receiving the fixed interest rate on the resulting swaps contract. Interest rate swaptions are complex instruments and the intrinsic value of a swaption requires schemes both to have an assessment of the market’s expectation of the future evolution of interest rates as well as the ability to carry out a theoretical swap valuation. Both these pieces of information are difficult to define in generality.

The number of schemes with swaptions strategies is currently anticipated to be extremely low and any such schemes would be expected to have the governance or ability to have specific stress analysis carried out by their asset manager or investment consultant. Such schemes should ask their asset manager or investment consultant to assist with the calculation.

Asset managers and investment consultants should note that:

  • The interest rate risk factor is a parallel shift in the spot rate curve. For swaption calculations, in theory the equivalent impact on the forward rates would need to be assessed. But applying the same parallel shift to the forward rate curve is a reasonable approximation.
  • Non-zero intrinsic values will only occur when the swaption is in-the-money. The intrinsic value in these cases will be the value of the swap contract assuming the swaption expires immediately and that the forward swap that forms part of the swaption contract is valued on the swap curve at the valuation date. This should be a positive value if the swaption is in the money – a minimum value of zero should be applied.

Calculations

The applicable exposure in respect of interest rate swaptions is:
(value of swaption after risk factor stress – value of swaption before stress) ÷ the sign and number of basis points corresponding to the interest rate risk factor stress.

This is the PV01 for the swaption.

The PV01 for those derivatives whose values change linearly with interest rates (including interest rate swaps, gilt repos, gilt futures and gilt total return swaps) can be obtained more simply, by considering the change in their value on a 0.01% rise in interest rates.

The value to enter as the interest rate risk stress factor impact is the total of the PV01s multiplied by the sign and number of basis points corresponding to the interest rate risk factor stress.

Inflation £

Calculations for inflation derivative strategies

An inflation derivative strategy is where a scheme enters a contract with another party to pay or receive a series of payments (or one single payment) whose amounts are determined, in whole or part, by the future movement of inflation rates. They are a common component of ‘LDI’ investment strategies. They typically include inflation swaps and protect the scheme’s funding level volatility from changes in inflation. Some schemes may enter these contracts directly with counterparties, or they can be entered into through pooled funds – often called ‘LDI pooled funds’.

Where a derivative contract is reflected in the inflation risk factor stress impact, the stress calculation quantifies the change in the value of the derivative associated with the inflation risk factor stress.

The inflation risk factor and interest rate risk factor stresses will be applied independently of each other.

The required exposure is the IE01 of the portfolio at the calculation date.

This can be obtained from the asset manager. This is the sensitivity of the portfolio value to a one basis point (or 0.01%) increase in inflation.

We expect that the IE01 will generally be a positive value, giving a negative risk factor stress impact when multiplied by the negative inflation stress factor. Positive inflation risk factor stress impacts may occur, for example if the relevant exposures are predominantly short. We would expect these situations to reflect short-term tactical decisions rather than long-term funding strategy.

Calculation of IE01

The applicable exposure, IE01, of inflation swaps can be calculated in a similar way to that for interest rate swaps.

The value to enter as the inflation risk factor stress impact is the total IE01 x the sign and number of basis points corresponding to the inflation risk factor stress.

Credit £

Calculations for credit derivative strategies

A credit derivative strategy is where a scheme enters a contract with another party to pay or receive a series of payments (or one single payment) whose amounts are determined by the future movement of credit spreads or credit events. The most common credit derivative is a credit default swap where the scheme has agreed to make a series of payments to buy or sell protection against the default of a corporate bond or corporate loan. They are commonly used by pension schemes to manage sizeable exposures to corporate bond/loan issuers or to mitigate the risk of sponsor insolvency.

The required exposure is the CDD01 of the portfolio at the calculation date.

This can be obtained from the asset manager. This is the sensitivity of the portfolio value to a one basis point (or 0.01%) increase in credit spreads.

If the scheme has bought credit protection, the value of this entry should be positive. If the scheme has sold credit protection, the value of this entry should be negative.

Calculation of CDD01

We would expect an allowance for basis risk on credit protection when calculating the CDD01. This allowance should be greater where the protection is not on the same reference bonds as the physical credit holdings – for example, where credit default swap index products, such as iTraxx, are used.

The value to enter as the credit risk factor stress impact is CDD01 x the sign and number of basis points corresponding to the credit risk factor stress.