Our views

The need for cashflow aware investment


Nick Woodward, Head of Investment Solutions

6 June 2017

The challenges for DB schemes
Many schemes have been plunged into deficit through the post-financial-crisis period of low and falling yields, which has increased the projected value of schemes’ liabilities. Additional headwinds from bouts of volatility, such as fears over the eurozone and jitters about China, have added to the difficulties of achieving a fully funded level. Additionally, with life expectancy increasing, people are living at around 15 years longer than expected in the 1950s. 
What steps have DB schemes been taking?
Common steps have included raising the normal retirement age and adjusting scheme accruals, but for many this has not been enough; increasing numbers of schemes are now closing not only to new members, but also to new accruals. This brings forward the tipping point at which a scheme becomes cashflow negative (i.e. the benefits to be paid out exceed the contributions paid in), and accelerates the scheme’s maturity date.
Long-term and short-term challenges require different solutions
The long-term challenge for DB schemes is how to plug their funding level deficit, and many invest in growth assets and riskier asset classes to boost their long-term returns. A lot of schemes are able to take advantage of their longer time horizons to invest in more illiquid assets, such as infrastructure and private equity, in order to reap the ‘illiquidity premium’. Another popular solution is Liability Driven Investment (LDI), which has increased in popularity in recent years, despite becoming more expensive to implement in a low and falling interest rate environment. 
These long-term solutions do not, however, address a significant short-term challenge of cashflows required on a regular basis to pay benefits. The danger for many schemes lies in having a sizeable deficit while also being cashflow negative, as this may result in becoming a forced seller of assets at inopportune times. If a higher proportion of the scheme’s assets are in riskier, more illiquid investments in order to bridge its deficit, having to sell these assets to meet short-term cashflow requirements can affect longer term returns. At RLAM, we think that cashflow matching strategies are an important part of the solution. 
Cashflow aware investing: the concept
50% of FTSE350 pension schemes are already (or are soon to be) ‘cashflow negative’. The chart below shows a typical scheme liability profile, and the effectiveness of a typical mixture of bond indices (incorporating gilts, corporate bonds and index linked gilts) in meeting them. Although a portion of the scheme’s cashflows is met, the mismatch is clear, and shows why many schemes have to plug cashflow gaps by selling growth assets.

The challenges for DB schemes

Many schemes have been plunged into deficit through the post-financial-crisis period of low and falling yields, which has increased the projected value of schemes’ liabilities. Additional headwinds from bouts of volatility, such as fears over the eurozone and jitters about China, have added to the difficulties of achieving a fully funded level. Additionally, with life expectancy increasing, people are living at around 15 years longer than expected in the 1950s. 

What steps have DB schemes been taking?

Common steps have included raising the normal retirement age and adjusting scheme accruals, but for many this has not been enough; increasing numbers of schemes are now closing not only to new members, but also to new accruals. This brings forward the tipping point at which a scheme becomes cashflow negative (i.e. the benefits to be paid out exceed the contributions paid in), and accelerates the scheme’s maturity date.

Long-term and short-term challenges require different solutions

The long-term challenge for DB schemes is how to plug their funding level deficit, and many invest in growth assets and riskier asset classes to boost their long-term returns. A lot of schemes are able to take advantage of their longer time horizons to invest in more illiquid assets, such as infrastructure and private equity, in order to reap the ‘illiquidity premium’. Another popular solution is Liability Driven Investment (LDI), which has increased in popularity in recent years, despite becoming more expensive to implement in a low and falling interest rate environment. 

These long-term solutions do not, however, address a significant short-term challenge of cashflows required on a regular basis to pay benefits. The danger for many schemes lies in having a sizeable deficit while also being cashflow negative, as this may result in becoming a forced seller of assets at inopportune times. If a higher proportion of the scheme’s assets are in riskier, more illiquid investments in order to bridge its deficit, having to sell these assets to meet short-term cashflow requirements can affect longer term returns. At RLAM, we think that cashflow matching strategies are an important part of the solution. 

Cashflow aware investing: the concept

50% of FTSE350 pension schemes are already (or are soon to be) ‘cashflow negative’. The chart below shows a typical scheme liability profile, and the effectiveness of a typical mixture of bond indices (incorporating gilts, corporate bonds and index linked gilts) in meeting them. Although a portion of the scheme’s cashflows is met, the mismatch is clear, and shows why many schemes have to plug cashflow gaps by selling growth assets.

One potential remedy is to abandon the benchmark investing approach, and to reshape the bond portfolio to represent the income needs of the scheme. This returns to thinking about pension schemes as divided into two categories: pensioners and non-pensioners. 

For the pensioners, you have a bond portfolio to match the near-term income need, where there is far more certainty of requirements. This is effectively a DIY ‘buy-in’, but without huge cost. For the mid- to long-term non-pensioners (active and deferred), the scheme can continue to invest in range of long-term growth assets, leaving these untouched because near-term income requirements have already been met.

Cashflow aware investing is an old solution to new challenge, and at RLAM, our cashflow aware approach, using active management to construct portfolios designed to provide income security from high quality assets, tackles income challenges head-on.

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The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.