John McAleer and Graham Wardle of the Running Off Mature Schemes Working Party discuss the rise of cashflow driven investment.
In the May issue of The Actuary, we looked at the challenges facing mature defined benefit pension schemes and presented a framework for managing their run-off. This follow-up article examines how cashflow driven investment (CDI) strategies could be used as schemes mature.
Many schemes are now cashflow negative, whereby income received from contributions and investments is less than outflow from the scheme's benefit payments, expenses and payments required to meet collateral obligations on derivative contracts. This is often a result of members seeking to access the defined contribution pension flexibilities introduced in 2015.
Serious funding challenges can arise from being cashflow negative. In particular, if the scheme becomes a forced seller of assets, it may have to lock into investment losses, making it very difficult to get back on track. This could be particularly painful for mature schemes, as they may not have the luxury of being able to wait for asset prices to bounce back. This is an important issue for mature schemes to consider, as has been highlighted by The Pensions Regulator.
What is cashflow driven investment?
The general principle underlying a CDI strategy is to match the expected benefit outgo with a fairly stable income from the scheme's assets. For mature schemes where long-term nominal and real cashflows are more predictable (with a prudence margin for member optionality and demographic uncertainties), a high degree of matching can be a realistic aspiration.
This is not a particularly new concept within the industry, but it has gained more traction during the past few years. This is because many schemes have become cashflow negative and funding levels have improved, enabling schemes to consider de-risking their investment strategies.
What assets typically form part of a CDI strategy?
Various asset classes can be used for a CDI strategy, depending on a scheme's beliefs, objectives and level of risk or return. CDI strategies can be broadly grouped into the areas set out in Figure 1.
It is worth noting that the majority of what are typically regarded as CDI assets fall within groups 2, 3 and 4 in Figure 1, and are mainly focused on different forms of 'credit beta' (ie assets that should rise in value as benchmark interest rates fall or credit spreads tighten). Some CDI strategies seek to target 'contractual cashflows'.
Why would schemes put a CDI strategy in place?
There are several reasons why schemes might implement a CDI strategy:
- To provide a degree of certainty over cashflows required to pay benefits
- To build a 'self-sufficient' investment portfolio (where there is low chance of additional funding being required from the sponsor)
- For overall risk and return preferences - for example, a preference for 'credit beta'
- To enhance expected returns from current Liability Driven Investment (LDI) assets.
Does this spell the end of LDI?
No. LDI will likely continue to be a key part of the investment strategy, even if schemes adopt a CDI -focused investment approach. This is because LDI can be utilised:
- To match the inflation linkage inherent in liability cashflows, and reduce the interest rate component of reinvestment risk
- To generate liquidity (ie cash) at short notice and at reasonable cost, largely by borrowing from the money markets and posting gilts as collateral ('gilt repo')
- To manage risk without requiring full commitment of capital.
What are the risks of a CDI strategy?
While there are several benefits to adopting a CDI strategy, it is important that schemes are aware of the risks and manage them appropriately through an Integrated Risk Management framework. Risks can include:
- Default risk - This should be consistent with the scheme's ability to manage downside risk
- Liquidity and reinvestment risk - Consideration needs to be given to the potential variation of scheme outgo over the shorter term and how this impacts liquidity or reinvestment requirements
- Change in forward-looking assumptions - Significant uncertainty remains over long-term benefit outgo projections. This is even the case for very mature schemes, as recent changes in life expectancy have illustrated.
- Employer covenant change - A lack of flexibility in a CDI strategy (such as a high allocation to illiquid assets) could expose schemes to any risk posed by a change in covenant
- Buyout - If securing the scheme benefits in full with an insurer, some illiquid assets may not be desirable for an insurer to take on as part of the transfer - increasing the cost to the sponsor.
These risks are particularly prevalent for mature schemes (where time is short and there is less scope for corrective action) and smaller schemes (which may have a lower governance budget).
The scheme actuary should consider how best to allow for the CDI strategy in their scheme-funding assumptions. An important point here is that the expected returns from the CDI strategy should be the starting point for the derivation of the discount rate, with an appropriate margin for prudence.
Looking to the future
As schemes continue to mature, the Running Off Mature Schemes Working Party expects an increased focus on cash management, synthetic strategies (using derivatives and other unfunded vehicles to access equity and credit markets, alongside traditional LDI) and matching insurance company asset positions (where buyout is the end target).
It is important to stress that CDI is not a silver bullet, but may become an important part of schemes' overall asset allocation as they continue to mature.
John McAleer is an actuary and senior consultant, Aon
Graham Wardle is portfolio manager at Legal & General Investment Management
Find the Running Off Mature Schemes Working Party's full research paper at www.actuaries.org.uk/documents/running-mature-schemes