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PENSIONS WEBINAR – THE PENSIONS
SORP INVESTMENT DISCLOSURES
PENSIONS
Philip Briggs
Fair value hierarchy
• FRC published FRED 62 in March 2016 which changed FRS 102 to bring the
disclosures in relation to the FVH into line with FRS 102.
• This amendment is effective for accounting periods commencing on or after 1
January 2017, with early application permitted.
• Note in accounting policies required if early adopting.
• PRAG Guidance was updated in May 2016.
Fair value hierarchy – our experience of audit issues
• Who has been responsible for making the determination?
• Compliance with the PRAG/Investment Managers Association guidance.
• Is this an appropriate source?
• Consideration and approval of the disclosure.
• Mixed treatment of Bonds and Gilts.
• Treatment of Pooled Investment Vehicles generally consistent.
• Watch out for AVCs.
Fair value hierarchy – our tip
Don’t think of as:
• Level 1 – Easy to price
• Level 2 – Not so easy to price
• Level 3 – Difficult to price
Think of as:
• Level 2 – Straightforward to price
• Level 1 – Very easy to price
• Level 3 – Difficult to price
Investment risk disclosures
Market
Risk
Currency risk
Interest rate risk
Other price risk
Credit risk
‘A retirement benefit plan shall disclose information that
enables users of its financial statements to evaluate the
nature and extent of credit risk and market risk arising
from financial instruments to which the retirement
benefit plan is exposed at the end of the reporting
period.
For each type of credit and market risk arising from
financial instruments, a retirement benefit plan shall
disclose:
a) the exposures to risk and how they arise;
b) its objectives, policies and processes for managing
the risk and the methods used to measure the risk;
and
c) the changes in (a) or (b) from the previous period.
(FRS 102 34.43 – 34.44)’
Investment risk disclosures
Credit risk
Counterparty risk
‘The risk that one party to a financial
instrument will cause a financial loss for
the other party by failing to discharge an
obligation.’ (FRS 102: Glossary)
Market risk
Economic
exposure
risk
Currency risk
Interest rate risk
Other price risk
Credit risk
Investment risk disclosures – credit risk
• Need to determine the counterparty.
• Cash.
• And can the counter part be credit rated?
‘I promise to pay the bearer on
demand the sum of …. pounds.’
Investment risk disclosures – credit risk
• And if your cash is in a bank then the bank will have a credit rating – the Trustees
will have made a decision about credit ratings that they will accept for banks that
they use – wouldn’t they?
Investment risk disclosures – credit risk - equities
• What about Equities?
• Equity represent an ownership interest so there is typically no credit risk.
Investment risk disclosures – credit risk - bonds
• Bonds are debt instruments.
• Bonds are probably the most important investment type to apply a credit risk policy
– so there will be quite a lot to say here.
• Credit risk is such a fundamental aspect of bond valuation that the
trustees/investment manager will have some form of policy and understanding of
bond credit ratings.
Investment risk disclosures – credit risk - properties
• What about Properties?
• Properties represent an ownership interest and so there is no credit risk.
Investment risk disclosures – credit risk - derivatives
• Derivatives are typically investments comprising contractual agreements with
counterparties – so there will be quite a lot to say here.
• Credit risk is such a fundamental aspect of derivative operations that the
trustees/investment manager will have some form of policy and understanding of
counterparty credit ratings and this will link with the collateral requirements.
Investment risk disclosures – credit risk - PIVs
• Credit risk is dependent upon the structure of the PIV.
Anatomy of a CIS
Investment manager
Investment decisions
Custodian
Safekeeping of
investments
Executing transactions
Administrator
Registering of investors
Recording transactions
in units
Depositary
Other governance
oversight
Promoter
Marketing and
distribution Collective
Investment
Scheme
Anatomy of a unit-linked insurance policy
Custodian
Safekeeping of
investments
Executing transactions
Investment manager
Investment decisions
Marketing and distribution
administration
Insurance
Company
Investment risk disclosures – credit risk - PIVs
And why is this also important?
How safe are your DC assets?
A report from the Security of Assets Working Party.
February 2016
Investment risk disclosures – credit risk - PIVs
• In a Collective Investment Scheme you own a share of the CIS and therefore it is
like an equity holding and represents an ownership interest and so there is no credit risk.
• Most common types of CIS are Authorised Unit Trusts and Open Ended Investment Companies (OEICs).
• With a unit linked insurance policy the trustees effectively have a contract of insurance with an insurance company.
• The insurance company will typically be credit rated – but the complexities of how insurance providers structure their businesses make this quite tricky to pin down.
• Other most likely form of PIV are Shares in Limited Liability Partnerships (ownership interest).
• Other forms of PIV may exist.
• Common industry consensus appears to be that PIVs are unrated – but it is not that simple.
Investment risk disclosures – credit risk - PIVs
• As PIVs are typically determined to be unrated then relevant credit risk information
relates to the structure and regulatory environment in which the trustees are
investing – so we see the following:
• But as the structures and regulatory environments differ then better quality
disclosure is provided by being more specific and providing an analysis of this.
The Scheme’s holdings in pooled investment vehicles are unrated. Direct credit risk
arising from pooled investment vehicles is mitigated by the regulatory environments
in which pooled managers operate and diversification of investments amongst a
number of pooled arrangements. The Investment Sub Committee, acting on behalf
of the Trustees, manages and monitors the credit risk arising from its pooled
investment arrangements by considering the nature of the arrangement, the legal
structure and regulatory environment.
Investment risk disclosures – credit risk PIVs
So a table works well to demonstrate this.
A summary of pooled investment vehicles by type of arrangement is as follows:
2016
£’000
2015
£’000
Unit linked insurance contracts 800 750
Authorised unit trusts 5,000 5,500
Open ended investment companies 400 450
Shares of limited liabilities partnerships 300 650
Total 6,500 7,350
Investment risk disclosures – credit risk PIVs
But a table does not necessarily work as
well to demonstrate overall credit risks.
2016
Investment
grade
£m
Non-
investment
grade
£m
Unrated
£m
Total
£m
Direct
Bonds 14,000 900 600 15,400
OTC derivatives
(fair value)
600 - - 600
Cash 1,500 - - 1,500
Repurchase
agreements
5 - - 5
Unsettled trades 100 - 30 130
Securities on loan 4,500 - - 4,500
Property rent
debtors
- - 8 8
Indirect
Pooled investment
vehicles
50 - 8,500 8,550
20,755 900 9,138 30,693
Analysis of direct credit risk
Investment
grade
£’000
Non-investment
grade
£’000
Unrated
£’000
Total
£’000
At 31 March 2016
Bonds 1,200,000 - - 1,200,000
OTC Derivatives (70,000) - - (70,000)
Longevity swap (50,000) - - (50,000)
Cash 800 - - 800
Money market investments 40 - - 40
Other investment balances (700,000) - 2,000 698,000
Pooled Investment Vehicles - - 800,000 800,000
380,840 - 802,000 1,182,840
Investment risk disclosures – credit risk PIVs
Particularly if your table looks like this:
Analysis of direct credit risk
2016
Investment grade Non-investment grade Unrated Total
£ £ £ £
Pooled investment vehicles - - 79,000,000 79,000,000
2015
Investment grade Non-investment grade Unrated Total
£ £ £ £
Pooled investment vehicles 78,000,000 78,000,000
‘A retirement benefit plan shall disclose by class of financial instrument:
a) The amount that best represents its maximum exposure to credit risk at the end of the reporting period. This
disclosure is not required for financial instruments whose carrying amount best represents the maximum
exposure to credit risk.
b) A description of collateral held as security and of any other credit enhancements, and the extent to which these
mitigate credit risk.
c) The amount by which any related credit derivatives or similar instruments mitigate that maximum exposure to
credit risk.
d) Information about the credit quality of financial assets that are neither past due nor impaired.
When a retirement benefit plan obtains financial or non-financial assets during the period by taking possession of
collateral it holds as security or calling on other credit enhancements (eg guarantees), and such assets meet the
recognition criteria in other sections, a retirement benefit plan shall disclose:
a) The nature and carrying amount of the assets obtained; and
b) When the assets are not readily convertible into cash, its policies for disposing of such assets or for retaining them.
(FRS 102 34.45 – 34.46)’
Additional credit risk disclosures.
Investment risk disclosures – credit risk
Investment risk disclosures – market risk
• FRS 102 defines market risk as ‘the risk that the fair value or future cash flows of a
financial instrument will fluctuate because of changes in market prices.’ (FRS 102: Glossary)
• So essentially we are considering the economic exposure risk.
• FRS 102 then states that ‘Market risk comprises three types of risk: currency risk, interest rate risk and other price risk.’ (FRS 102: Glossary)
• Two primary options exist for addressing this disclosure requirement:
– sophisticated strategic basis of disclosure; and
– direct compliance basis.
• Unfortunately too many schemes ended up somewhere in between.
Example
investment
classifications
Sophisticated strategic approach Direct Compliance approach
Equities Match disclosure to the strategic investment decisions based on
economic exposure – consider any hedging strategies. Other price
risks are more granular than those referred to in FRS 102. May also
link to wider risks such as covenant, funding or longevity risks.
Overseas domiciled equities link to currency risk – all
equities link to Other price risks.
Bonds Match disclosure to the strategic investment decisions based on
economic exposure – consider any hedging strategies. Other price
risks are more granular than those referred to in FRS 102. May also
link to wider risks such as covenant, funding or longevity risks.
Overseas domiciled bonds link to currency risk – all
bonds link to interest rate risks.
Derivatives Match disclosure to the strategic investment decisions based on
economic exposure – consider any hedging strategies. Other price
risks are more granular than those referred to in FRS 102. May also
link to wider risks such as covenant, funding or longevity risks.
The links to currency , interest rate and other risks is
likely to be relatively clear based on the nature of the
derivative – ie forex contracts or interest rate swaps.
PIVs Adopt a look through approach to consider the underlying exposures
within the PIVS.
At a high level cross reference each PIV or groups of
PIVs to currency, interest rate and other risks – also
linking to the existence of indirect credit risk enhances
the credit risk disclosures.
Investment risk disclosures – market risk
Investment risk disclosures – market risk
• But remember the requirement is that: ‘A retirement benefit plan shall disclose
information that enables users of its financial statements to evaluate the nature and
extent of credit risk and market risk arising from financial instruments to which the
retirement benefit plan is exposed at the end of the reporting period.’ (FRS 102
34.44)
• This means some form of quantification.
• Two primary options exist for addressing this disclosure requirement:
– the vague % exposure basis; and
– direct amount basis.
Market risk disclosures examples
Investment risk
disclosures – market
risk examples.
(iii) Currency risk
The scheme is subject to currency risk because some of the Scheme’s investments are held in
overseas markets, either as segregated investments or via pooled investment vehicles. The
Trustees have set a benchmark limit to overseas currency exposure of 15% of the total portfolio
value which is achieved through a currency hedging policy. This was the net currency exposure at
the year-end.
(ii) Currency risk
The Trust is subject to currency risk because
some of the Trust’s investments are held in
overseas markets via pooled investment
vehicles. The Trustee limits overseas currency
exposure through a currency hedging policy.
The Trust’s total net unhedged exposure by
major currency at the year end was as follows:
2015 2014
£’000 £’000
Currency
Euro 8,000 3,000
Japanese Yen 17,000 2,200
US Dollar 135,000 230,000
Example Market risk disclosures – typical PIV approach.
Investment risk disclosures – market risk
Credit Risk Market risk
Direct Indirect Currency Interest
rate
Other
price
05.04.2016 05.04.2016
Pooled investment vehicles
- UK Equity Y N N N Y 4,700,000 5,000,000
- Overseas Equity Y Y Y N Y 4,800,000 5,100,000
- UK Corporate Bonds Y Y Y Y N 6,000,000 6,000,000
- UK Index-Linked Gilts Y Y N Y Y 3,000,000 3,000,000
- Diversified Growth Y Y Y Y Y 2,000,000 1,500,000
Total Investments 20,500,000 20,600,000
The following table summarises the extent to which the various classes of investments are
affected by financial risks:
Investment risk disclosures – qualitative
‘A retirement benefit plan shall disclose information
that enables users of its financial statements to
evaluate the nature and extent of credit risk and market
risk arising from financial instruments to which the
retirement benefit plan is exposed at the end of the
reporting period.
For each type of credit and market risk arising from
financial instruments, a retirement benefit plan shall
disclose:
a) The exposures to risk and how they arise;
b) Its objectives, policies and processes for
managing the risk and the methods used to
measure the risk; and
c) The changes in (a) or (b) from the previous period.
(FRS 102 34.43 – 34.44)’
Market
Risk
Currency risk
Interest rate risk
Other price risk
Credit risk
Investment risk disclosures – quantitative
‘A retirement benefit plan shall disclose information
that enables users of its financial statements to
evaluate the nature and extent of credit risk and market
risk arising from financial instruments to which the
retirement benefit plan is exposed at the end of the
reporting period.
For each type of credit and market risk arising from
financial instruments, a retirement benefit plan shall
disclose:
a) The exposures to risk and how they arise;
b) Its objectives, policies and processes for
managing the risk and the methods used to
measure the risk; and
c) The changes in (a) or (b) from the previous period.
(FRS 102 34.43 – 34.44)’
Market
Risk
Currency risk
Interest rate risk
Other price risk
Credit risk
Investment risk disclosures – don’t forget in year 2
‘A retirement benefit plan shall disclose information
that enables users of its financial statements to
evaluate the nature and extent of credit risk and market
risk arising from financial instruments to which the
retirement benefit plan is exposed at the end of the
reporting period.
For each type of credit and market risk arising from
financial instruments, a retirement benefit plan shall
disclose:
a) The exposures to risk and how they arise;
b) Its objectives, policies and processes for
managing the risk and the methods used to
measure the risk; and
c) The changes in (a) or (b) from the previous period.
(FRS 102 34.43 – 34.44)’
Market
Risk
Currency risk
Interest rate risk
Other price risk
Credit risk
Investment risk disclosures – final points
• Fully insured arrangements require particular consideration.
• More sophisticated financial instruments require deeper consideration – ie Repos,
special purpose vehicles.
• For DC investments the sophisticated strategic approach is unlikely to be
appropriate.
• Annuity policies are financial instruments and form part of the investment strategy.
• AVCs need to be considered.
• Much time and costs have been wasted approaching these disclosures from
strategic investment principles rather than compliant financial reporting principles.
• As experience grows and practice develops we hope clients will be challenged to
improve.
QUESTIONS
AND ANSWERS?
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