Skip to main content
The Actuary: The magazine of the Institute and Faculty of Actuaries - return to the homepage Logo of The Actuary website
  • Search
  • Visit The Actuary Magazine on Facebook
  • Visit The Actuary Magazine on LinkedIn
  • Visit @TheActuaryMag on Twitter
Visit the website of the Institute and Faculty of Actuaries Logo of the Institute and Faculty of Actuaries

Main navigation

  • News
  • Features
    • General Features
    • Interviews
    • Students
    • Opinion
  • Topics
  • Knowledge
    • Business Skills
    • Careers
    • Events
    • Predictions by The Actuary
    • Whitepapers
    • Moody's - Climate Risk Insurers series
    • Webinars
    • Podcasts
  • Jobs
  • IFoA
    • CEO Comment
    • IFoA News
    • People & Social News
    • President Comment
  • Archive
Quick links:
  • Home
  • The Actuary Issues
  • June 2021
General Features

Cashflow driven investment strategies for DB pension schemes

Open-access content Wednesday 2nd June 2021
Authors
Derek Steeden
Kedi Huang

Derek Steeden and Kedi Huang discuss how cashflow-driven investment can help defined benefit pension schemes manage cashflow and meet long-term funding targets

web_p18-19_CDI_CREDIT_iStock-1217057529_v2.jpg

As a defined benefit (DB) pension scheme matures, its investment strategy needs to increasingly focus on delivering income to pay benefits, to avoid having to sell assets at short notice in potentially volatile markets. How can this be achieved with a high degree of confidence while generating a sufficient investment return to reach full funding on a low-risk basis? Cashflow-driven investing aims to solve this challenge, meeting both growth and liability matching objectives.

Government bonds and investment grade credit form the core of a cashflow-driven investment (CDI) strategy, as bonds can be matched to a target cashflow profile with a high degree of confidence. But with many schemes being less than 80% funded on a low-risk basis, higher returns are needed. Traditionally, growth assets such as equities are held to deliver higher returns until it is affordable to switch equities into bonds. However, there is a risk that a persistent deficit will remain if those assets do not deliver the returns required of them, and so de-risking might never proceed.

Reducing the risk

Our research shows that adopting a CDI approach can mitigate this downside risk as, when held to maturity, assets such as private debt can deliver greater liability-matching without the low returns associated with investment-grade bonds, or the capital volatility associated with equity. This is illustrated in Figure 1.

 

web_p18
Figure 1: Funding level projection. 

 

We modelled the evolution of the funding level (on a low-risk valuation basis) over the next 15 years for a scheme with typical asset allocation (source: the Pension Protection Fund). The 5% and 95% percentiles of funding level are shown by the blue lines in Figure 1. While the funding level rises to reach 100% in the central scenario, there is a significant chance of a persistent deficit (a 5% chance that the funding level remains below 70%). 

Switching to a CDI investment approach, shown by the shaded pink area, involved no loss of expected return – the funding level in the central scenario is similar to the traditional asset allocation.  However, the risk of a persistent deficit remaining is reduced.

The journey to maturity

Let’s explore the characteristics of schemes as they transition to a de-risked position. The range of asset classes discussed, and their potential match to the CDI strategy objectives, are summarised in Figure 2.

 

web_p19
Figure 2: CDI asset classes. 

 

1. A young DB scheme will have many years before significant liability cashflows fall due. This is the time to seek assets offering attractive yields that will benefit from inflation exposure in the decades to come, particularly where ownership of the underlying asset provides additional security. ‘Real assets’ – for example real estate, infrastructure, and natural resources such as timber and wind farms – offer many of these features. Precise cashflow matching will not be possible, as few fixed income assets exist beyond 30 years and those that do may limit the scheme’s options in future years. In any case, other risk factors will dominate. These could include derivative and foreign exchange mark-to-market moves, or changes in the liability profile due to members who have not yet retired. 

2. As scheme funding improves and the level of return required from assets reduces, predictable cashflows become more feasible to secure. The scheme can now purchase assets with higher credit quality, but still needs a sufficiently high investment return to reach full funding on a low-risk basis.

Private credit is helpful in offering a higher yield than public market debt for similar credit risk, but involves more complex underwriting due to information barriers and its lower liquidity. Proceeds from closed-ended funds can be used to build up the low-risk portfolio as this becomes affordable, with the aim of achieving substantial low-risk exposure by the time the scheme is significantly mature (ie when most members have retired). Implementation is key, as capital may need to be invested over a period of time and deployed opportunistically to build a diversified portfolio.

Synthetic opportunities also exist – credit-linked notes, for instance. These offer credit exposure to a particular bond using credit default swaps (CDS), which may offer a higher yield due to the difference in liquidity between bond and CDS markets and other market-related factors.

In this phase it is important to articulate the scheme’s liquidity needs. Measuring liquidity in terms of transaction costs alone can result in schemes retaining inappropriate capital risk from public equities; liquidity may be more usefully defined as the ability to meet cash outflows, measured using stress tests. Cash, short-dated assets and liquid bonds provide a liquidity ladder and the flexibility to transact a partial bulk purchase of annuity earlier than expected if pricing becomes attractive.

3. As a scheme nears full funding on a low-risk basis (which we define as a discount rate of less than gilts + 1% per annum), full cashflow matching becomes a realistic target. The long-dated credit built up in stage 2, together with gilts to fill gaps in the portfolio, can provide a high level of predictable cashflows with reasonable liquidity. Global diversification will be needed, as the long-dated UK credit market is simply too small: we estimate that the outstanding stock of investment grade credit of duration greater than 15 years is five times smaller than outstanding pension liabilities of like duration. Schemes typically target a yield above that required to maintain full funding in order to provide a buffer against residual risks such as changes in life expectancy, ‘unhedgeable’ features of liabilities, or unexpected credit loss.

Things to consider

Across all three phases, interest rate and inflation hedging are essential. Sources of contractual inflation-linkage outside of index-linked gilts remain scarce; the UK corporate index-linked market is currently around £40bn, with an average real yield of -1.2% (source: Bloomberg, 30 March 2021). Even funds with an ‘inflation plus’ target often have, at best, a broad linkage to inflation. This broad linkage can be accommodated within a liability-driven investment programme by adjusting the target inflation hedge ratio down to reflect the contribution expected from those assets.

Our final consideration is market size. Many assets with desirable CDI characteristics, such as unlisted infrastructure debt where annual capital raised is around £30bn, are in high demand – so care is needed to ensure that the yield offers fair compensation for the risk.

By incorporating a wider range of fixed income and real assets tailored to the liability profile, a CDI framework can enable more de-risking to take place sooner than traditional investment approaches.

Derek Steeden is a CDI portfolio manager at Invesco

Kedi Huang is a vice president at Nomura and chair of the IFoA CDI Working Party

 

Image credit | iStock

ACT Jun21_Full.jpg
This article appeared in our June 2021 issue of The Actuary .
Click here to view this issue

You may also be interested in...

web_p15_Climate_CREDIT_Alex Williamson-Ikon_00001105.jpg

Climate risk scenarios for pension schemes

What might climate-related risk analysis look like for pension schemes? Neil Mitchell, Claire Jones and Lisa Eichler investigate
Wednesday 2nd June 2021
Open-access content
web_p11_race-to-Zero_CREDIT_iStock.jpg

A future worth having: updated guide for pension actuaries

Esther Hawley and Sandy Trust on the IFoA’s new guide for actuaries working in defined contribution pensions, and why such schemes should commit to net zero today
Wednesday 2nd June 2021
Open-access content
web_p30-31_Pooled-Annunities_CREDIT_Getty_83461805

Staying the course: how pooled annuity funds are proving an attractive alternative

Thomas Bernhardt and Catherine Donnelly describe how pooled annuity funds are an attractive alternative to lifetime annuities and income drawdown in providing a retirement income for life
Wednesday 5th May 2021
Open-access content
Slice Risk

Are guarantees in retail products falling out of favour?

Brandon Horwitz considers whether guarantees in retail products have a future in the UK
Wednesday 5th May 2021
Open-access content
web_p20_PRO_CREDIT_iStock-531057937.jpg

Weighing the options of PPOs

Peter Towers and Justin Thomas explain the falling popularity of PPOs in claim settlements, and their implications for insurers
Wednesday 2nd June 2021
Open-access content
Europe's largest pension fund joins net-zero initiative

Europe's largest pension fund joins net-zero initiative

ABP – which is Europe's largest public sector pension scheme by assets under management – has today committed to decarbonising its portfolio using the Net Zero Investment Framework (NZIF).
Tuesday 8th June 2021
Open-access content

Latest from Pensions

ers

By halves

Reducing the pensions gap between men and women is a work in progress – and there’s still a long way to go, with women retiring on 50% less than men, says Alexandra Miles
Thursday 2nd March 2023
Open-access content
rdth

Make My Money Matter's Tony Burdon on the practical power of sustainable pensions

Years working in international development showed Tony Burdon, head of Make My Money Matter, that sustainable pensions can harness trillions of pounds to build a better world – at a scale governments and charities can’t. He talks to Travis Elsum
Wednesday 1st March 2023
Open-access content
KV

Liability-driven investments: new landscape

What now for liability-driven investments, after last year’s crash in the market? Pensions experts Rakesh Girdharlal and Moiz Khan say it should lead to a more balanced approach
Wednesday 1st February 2023
Open-access content

Latest from Investment

KV

Liability-driven investments: new landscape

What now for liability-driven investments, after last year’s crash in the market? Pensions experts Rakesh Girdharlal and Moiz Khan say it should lead to a more balanced approach
Wednesday 1st February 2023
Open-access content
cj

Natural capital investing

Chris Howells and Andrew Dreaneen discuss how today’s investments in natural capital profit portfolios as well as the planet and humanity
Wednesday 1st February 2023
Open-access content
t

Options open on making portfolios more climate-friendly

Michael Sher sets out the option savailable to investors who are looking to improve their portfolios’ climate credentials
Wednesday 2nd November 2022
Open-access content

Latest from General Features

yguk

Is anybody out there?

There’s no point speaking if no one hears you. Effective communication starts with silence – this is the understated art of listening, says Tan Suee Chieh
Thursday 2nd March 2023
Open-access content
ers

By halves

Reducing the pensions gap between men and women is a work in progress – and there’s still a long way to go, with women retiring on 50% less than men, says Alexandra Miles
Thursday 2nd March 2023
Open-access content
web_Question-mark-lightbulbs_credit_iStock-1348235111.png

Figuring it out

Psychologist Wendy Johnson recalls how qualifying as an actuary and running her own consultancy in the US allowed her to overcome shyness and gave her essential skills for life
Wednesday 1st March 2023
Open-access content

Latest from June 2021

web_p4_dan-head7.png

Tackling sensitive topics

This month we interview Kristian Niemitz, head of political economy at the IEA, who posits that there is a better way to organise a health system than the NHS, in order to deliver improved outcomes (p12).
Wednesday 2nd June 2021
Open-access content
web_p44_Obituary_Nicolas Hornby Taylor FIA_Nick-Taylor_Life-article.jpg

People and society news: June

People and society news: June
Wednesday 2nd June 2021
Open-access content
web_p12-13_Interview_KN3new-tools-final_Illustration_Sarah-Auld_iStock.jpg

An alternative proposal: reforming the NHS

Kristian Niemietz talks to Chris Seekings and Ruolin Wang about his controversial ideas for reforming the UK’s National Health Service
Wednesday 2nd June 2021
Open-access content
Share
  • Twitter
  • Facebook
  • Linked in
  • Mail
  • Print

Latest Jobs

Capital & Reserving, Nearly Newly

London (Greater)
Depending on experience
Reference
149031

Reserving Actuary

Dublin
Competitive
Reference
149027

Senior Analyst - Actuarial and Funding Risk

England, London
£60000 - £65000 per annum + bonus + benefits
Reference
149029
See all jobs »
 
 
 
 

Sign up to our newsletter

News, jobs and updates

Sign up

Subscribe to The Actuary

Receive the print edition straight to your door

Subscribe
Spread-iPad-slantB-june.png

Topics

  • Data Science
  • Investment
  • Risk & ERM
  • Pensions
  • Environment
  • Soft skills
  • General Insurance
  • Regulation Standards
  • Health care
  • Technology
  • Reinsurance
  • Global
  • Life insurance
​
FOLLOW US
The Actuary on LinkedIn
@TheActuaryMag on Twitter
Facebook: The Actuary Magazine
CONTACT US
The Actuary
Tel: (+44) 020 7880 6200
​

IFoA

About IFoA
Become an actuary
IFoA Events
About membership

Information

Privacy Policy
Terms & Conditions
Cookie Policy
Think Green

Get in touch

Contact us
Advertise with us
Subscribe to The Actuary Magazine
Contribute

The Actuary Jobs

Actuarial job search
Pensions jobs
General insurance jobs
Solvency II jobs

© 2023 The Actuary. The Actuary is published on behalf of the Institute and Faculty of Actuaries by Redactive Publishing Limited. All rights reserved. Reproduction of any part is not allowed without written permission.

Redactive Media Group Ltd, 71-75 Shelton Street, London WC2H 9JQ