Stephanie Hawthorne, award-winning journalist, interviews Sorca Kelly-Scholte on the need for cash flow investing.
The Pensions Regulator estimates more than 80,000 DB transfers were completed in the past year.
For pension schemes with negative cash flow it can be like ‘trying to fill up the bath with the plug out, and that is a problem a huge number of trustees and sponsors are facing right now,” says Sorca Kelly-Scholte.
An actuary and head of EMEA Pensions Solutions, and advisory at JP Morgan Asset Management with over 20 years’ experience, she stresses in particular the 2015 pension freedoms. These have created an immediate cash flow challenge for many firms. Across the industry, activity has been elevated with The Pensions Regulator estimating more than 80,000 DB transfers were completed in the past year. Some schemes have been scrambling to generate the cash to make these payments.
Kelly-Scholte comments: “They have been doing that in a relative benign period. We haven’t had much volatility. When there was a spike in February, the market reminds us that it is not always as orderly as it have been in the past two years.”
Clearly, the transfer activity is a challenge. Anecdotal evidence suggests this will carry on for a level higher than in the past, but at not quite as high level as in the immediate past. Kelly- Scholte forecasts that “this initial rush to the gates will settle down but at a higher level than we have seen historically. That will further increase the liquidity challenge of pension funds. It may mean that they run off their liabilities more quickly but the other side of the coin is that they will have a shorter time to manage the deficit problems.”
Kely-Scholte’s solution to this Kafkaesque nightmare is cash driven investing. “Three quarters of pension funds are in negative cash flow. Put simply, that means the amount of contributions being paid in is less that the amounts paid out.” This figure is based on JP Morgan’s research on firms in the FTSE 350, MSCI Europe and S&P 500. She adds “For some of these firms, they will only be slightly in negative cash flow and that can be dealt with by investment income in a straightforward manner, but half of these schemes are in negative cash flow to the tune of 2% of assets. Once you are past that level, you will have to think more deeply about how you are going to service those cash flows as it won’t simply be a case of using the investment income.”
Obviously, people focus on sterling assets because pension schemes have sterling liabilities that match inflation.
She refers to a survey Mercer did two years ago in which only a tiny minority of pension funds (around 4%), had begun to develop strategies specially designed to deal with negative cash flow. The vast majority of these were relying on investment income, or relying on the ability to sell assets in an orderly way, but that exposes the scheme to the risk of volatile markets or being a forced seller in stressed or volatile periods. That has the effect of locking losses and creating more volatility on the balance sheet.
“People say ‘what’s the big deal when pension funds are designed to pay out benefits? Why is this a surprise? Why is this a problem?’ But until now pension funds have had more coming in than they were paying out. They haven’t had to deal with cash flow servicing and also they expected they wouldn’t have to until such times as they were full and entered run off.” In the past people were preoccupied with deficit repair problems.
To Kelly-Scholte, setting a cash flow driven strategy is of the utmost importance. “I see more and more people equating cash flow investing to just buying a cash flow matched income portfolio. That may be part of how you address the problem but to us that is only appropriate once you are fully funded and very mature. Many schemes are not yet at the final run off. She warns against thinking of cash flow servicing as just an administrative thing that you deal with at the end of the process. You really need to think about it up front. “Once you are underfunded it creates an extra drag on your funding level.”
Kelly-Scholte says “I don’t think we have seen the emergence of any one solution. Some people are beefing up their allocations of income assets, particularly the mature schemes, building up bespoke fixed income portfolios, but others are grappling with how they are trying to find the right trade offer between the need to deliver return in order to repair the deficit alongside the need to service cash flow and the need to create some duration hedge i.e. the traditional LDI strategy.”
“The first thing pension scheme trustees should think about is incorporating cash flow into their overall strategy and thinking explicitly about what cash flows are coming off their assets and the degree of certainty or security there is. It is about thinking where do you want to end up?”
“For most schemes, it means a much larger allocation to credit than they have at the moment and that will be built in a customised manner and run, not against standard benchmarks, but run against a specification of their liability and cash flow. For most schemes it will probably mean an allocation to the cash flow generative but illiquid assets such as private credit, infrastructure debt and real estate.”
What about capacity? Won’t everyone want the same assets? “They are in short supply; this is why you need to start with this in mind because that kind of portfolio can take many years to build but you need to be a little but opportunistic.” says Kelly Scholte.
Obviously, people focus on sterling assets because pension schemes have sterling liabilities that match inflation. Indeed Kelly-Scholte says the larger schemes are already doing this and are finding it harder and harder to find the right assets. So, she emphasises, “you really need to think globally when you are building these kinds of strategies which takes you into currency management challenges but this is a manageable problem. Diversification is clearly important. The UK market has a low capacity and is also quite small and relatively concentrated. The US, by contrast, is ten times as large and has ten times as many individual issuers to choose from.” She says a lot of pension portfolios are dominated by LDI and equity high growth assets but there is a missing middle: credit and real assets which can really help deliver cash flow.