All too recently, pension schemes were plagued by apparently insurmountable funding deficits, with any notion of achieving a funding level surplus being firmly categorised in the realm of ‘fantasy’ or even ‘delusion’. Yet fast forward to today and we see many pension schemes having enjoyed sustained investment success, resulting in material funding level improvements, despite persistently low Gilt yields. Surely this heralds the end of almost a decade of pension trustee woes and angst? After all, what new problems could this improved position present when compared with the difficulties of the recent past?
Unfortunately, pension scheme trustees and advisers alike have had to learn the hard way that ‘with the rise of tomorrow, comes tomorrow’s problems’. For many pension schemes, the key issue has become managing a negative cash flow position, whilst seeking sufficient return in order to make good any remaining funding deficit. This issue has given rise to the prominence of Cashflow Driven Investing (CDI).
So, what is CDI?
Definitions of CDI differ hugely, but it can broadly be viewed as a strategy that seeks to match pension scheme cash outflows with predictable and secure income. The way in which income is achieved can vary substantially, but shorter term strategies typically utilise fixed term, amortising debt.
CDI strategies typically share three common features:
1. They can offer a yield in excess of gilts;
2. They can offer greater certainty of return versus a ‘traditional portfolio’; and
3. They represent a low governance solution.
CDI is certainly not a new concept, in fact the pension and insurance universe has been utilising this strategy for decades.
However, with the maturing of pension scheme liabilities (which has been exacerbated by many pension schemes closing to new entrants), and reductions in pension scheme income (through reduced deficit recovery and ongoing contributions), many pension schemes have found themselves in an increasingly negative cashflow position. As such, an investment strategy designed to manage cash flow has naturally received increasing interest.
How might a short term CDI solution help manage negative cash flow?
Negative cashflow introduces the very real risk of a pension scheme’s funding level being materially impacted as a result of having to sell assets in order to meet cash outflows at an inopportune time, such as when asset prices are depressed. Pension schemes have historically adopted three strategies, excluding CDI, to manage their negative cash flow position, including:
This strategy introduces two potential difficulties: (i) there is a potential opportunity cost; and (ii) the cash reserve will need to be replenished at some point, potentially before asset prices have recovered.
Holding a diversified portfolio of uncorrelated, liquid assets
The key drawback to this strategy is that during times of market stress, asset prices tend to be highly correlated. Therefore, pension schemes may still be forced to sell assets at depressed prices. Pension schemes may also find themselves exposed to greater downside risk than is necessary.
A combination of the two strategies detailed above
A suitable alternative cash flow strategy might focus on investing a portion of scheme funds in a portfolio of tailored corporate debt, the coupon and principal payments from which can be used to meet cash outflows. Such a portfolio can be structured to target a degree of outperformance in excess of gilts, subject to appropriately managing default risk. Remaining pension scheme assets can then potentially be invested in a combination of return seeking assets and Liability Driven Investment solutions to erode any remaining deficit and stabilise funding levels.
For many underfunded schemes, the ability to match all pension outflows is unrealistic despite a marginal pick up in return versus holding gilts.
However, a strategy that seeks to match the first. five years of outflows may not be unrealistic.
But what can this approach mean in practice?
There are a number of factors to consider when proposing this approach, and how it could work in practice. Whilst this short term approach to CDI is certainly not the golden goose, it can help to target a degree of outperformance above gilts, whilst satisfying immediate cash outflows, irrespective of the performance of the return seeking assets (the income from which is often not secure and can be unpredictable). Remaining pension scheme assets can then be put to work to help reduce any funding gap.
The time period to be covered is also another area that needs to be considered, though it is usually largely dependent upon affordability. Covering the first five years of outflows seeks to strike a balance between needing to provide sufficient protection in the event of a fall in the value of risk assets, whilst not unduly compromising the ability of the pension scheme to make good any remaining deficit.
Contributions are of course a crucial aspect that should be reviewed, but as they are known in advance they can easily be factored into a short term CDI strategy, subject to the Sponsor remaining solvent and active membership remaining broadly constant. The level of income required from the CDI portfolio to meet cash outflows is typically reduced by the level of deficit recovery contributions and other known, predictable income. However, there is always the risk of unexpected cash outflows. Such cash flows, by their very definition, are unpredictable and difficult to incorporate into a short term CDI strategy. Pension trustees may wish to undertake a liability management exercise in advance of introducing a short term CDI solution in order to ‘tidy-up’ their benefit payments and increase their predictability. Certain reasonable assumptions will then need to be made in order to allow for a degree of unexpected cash outflows.
The scheme’s experience here is key in determining whether a pattern of behaviour can be established, for example the percentage of members now selecting a transfer out at retirement in favour of a lump sum and pension. Whilst a short term CDI solution is not the panacea for all that ails pension schemes, it could certainly offer an attractive means of managing the risks associated with negative cash flow, whilst still allowing an appropriate level of return to be targeted to make good any remaining funding deficit. Such a strategy can also be viewed as a first step. For those schemes managing the path to Buy Out (or those with a reduced return requirement), targeting longer term CDI strategies may be appropriate. Such strategies focus on assets that may offer long term predictable and secure cash flows, such as infrastructure debt and ground rents, but that is a story for another day.
Senior Investment Consultant – Quantum Advisory