Cashflow Driven Investment

28 March 2018

BACKGROUND

Cashflow Driven Investment (CDI) strategies are the latest hot topic in pensions, but can seem confusing. Some think it is simply cash flow management and is only an option for schemes that need to disinvest to pay pensions. As scheme actuaries, we focus on the link between payments to members with funding and investment, and we see CDI as much more than simple cash flow monitoring. It allows you to rethink your investment strategy, properly linking it to your funding approach and potentially implement your journey plan today, rather than waiting for triggers to be met.

For the first in a series of articles, we want to set out the case for CDI so you can decide whether it could be the right strategy for your scheme. Future articles will go into more detail behind the supporting asset classes, the process required to work through your requirements and, finally, we will demonstrate the value of CDI by sharing the experiences of one of our clients.

WHY DO WE NEED CDI?

At its simplest level, you could implement CDI with a portfolio of buy and hold investment grade corporate bonds that match your future cash flows. Combine this with changing the discount rate to reflect the yield on the bonds held, and you could have a much more stable and predictable funding position. Most schemes though, hold equities and DGFs, for example, which have higher return expectations, but require a forecast of future returns which have a wide range of possible outcomes.

Over the last 10 years the majority of pension schemes have debated LDI and hedging, with most increasing the proportion held in gilts, possibly with leverage. This means that typically schemes are holding assets that are expected to yield below inflation in the long term. To compensate for this very low return in the long-term, a lot of schemes end up taking much higher levels of risk today, with the expectation of higher, but volatile returns over the short term, before locking into gilts or a buy-in.

Another common issue with current investment strategies is the high levels of liquidity – which is arguably not necessary given the long term horizons of most pensions schemes. Instead, why not pick up some illiquidity premium and properly map out your cashflow needs over the lifetime of the scheme? This does require some flexibility, particularly in the light of high levels of transfer values, and emphasises alternative assets classes such as infrastructure debt, direct lending, private debt, etc.

Finally, a properly integrated risk management approach makes it sensible to reduce the level of investment risk today, better matching the ability of the sponsor to support the scheme.

To address these issues, CDI uses a diversified portfolio of buy and maintain assets with contractual income to broadly match the expected payments to members over the lifetime of the scheme. Typically, this could reduce the return expectations over the short term (and give a significant reduction in risk) offsetting this with a modest increase in returns at the medium to long end. You may well decide to hedge the factors that impact the cashflows such as inflation or mortality, and you can use LDI to hedge interest rates.

Cashflow Driven Investment

MEMBER CASHFLOWS

The expected cashflows from a typical pension scheme stretch out for 60+ years. Pensioner payments don’t tend to change much, only moving when inflation changes, when people live a bit longer or perhaps don’t have a spouse when we assumed they did. For members who are yet to retire we have much more uncertainty. They could retire early, or take more tax-free cash or even take a transfer value. Some pensioners may even take part in a pension exchange exercise.

The goal of CDI is to put together a portfolio of assets which produce income that broadly matches these member cashflows. The assets typically used are cheaper than gilts, so give a modest boost to returns while reducing overall risk for most schemes.

Cashflow Driven Investment

THE ASSETS

A good starting point is to split the cash flows into broad buckets, say 0-10 years, 10-20 years, 20-30 years and over 30 years. Different opportunities exist in each bucket with typically higher returns at the start, reducing over time.

At the start of 2018, there was a wide universe of potential assets which have contractual cashflows and could be used to try and match the benefit cashflows, particularly at the shorter end, and produce returns in excess of investment grade corporate bonds.

The solution varies for each scheme, but typically we would expect to see return expectations between gilts + 0.5% to gilts + 1.5%, after allowance for defaults. Even for schemes using the full range of credit funds, returns start off around gilts + 1.5%, but once the higher yielding assets have matured, the remaining assets will tend to be investment grade bonds and gilts with returns around gilts + 0.5%.

ALIGN THE FUNDING APPROACH

The new investment strategy will need to be reflected in your technical provisions. This is not complicated - when we have done this before, we have simply set the discount rate to be the expected return on the portfolio adjusted for defaults and prudence. This direct link to the asset return should give a much more stable funding path, combined with a significant risk reduction.

As a side benefit, because CDI is closely linked to the return on corporate bonds, then you should get a better alignment with the Employer’s accounting disclosures under IAS19, i.e. more balance sheet stability.

SUMMARY

Implementing CDI allows you to construct a diversified, low cost portfolio of income and maturity proceeds from fixed income assets, designed to closely match the expected cashflows for your members. The discount rate assumption can then be aligned to the expected return on the assets held, after allowing for defaults and prudence.

For a scheme that moves to CDI from a more traditional approach with, say, higher return seeking assets at the start and then lower gilts after ten years, you should expect to see a significant reduction in risk, more stable funding, and the flexibility to cope with future uncertainty.

To discuss how CDI could work for your scheme, speak to your usual JLT contact or Roger Higgins, Director (roger_higgins@jltgroup.com).