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