Cashflow focused strategies should be viewed as a natural but increasingly important complement to current LDI strategies.
Pension schemes can exploit a wider universe of suitable assets rather than a narrow focus on contractual cashflow assets unless buyout is imminent.
This cashflow focused trend is still in its early stages, yet it is extremely clear that schemes do not have the luxury of time to not be thinking in this way.
Over recent years, the improvement in funding levels for defined benefit (DB) pension plans has amplified the importance of implementing de-risking strategies to hedge liabilities and ultimately bringing plans closer to their goal of securing benefits. This can be via the transfer of risk in the form of an annuity or buy-out with an insurer, or in a ‘self-sufficient’ state. Liability driven investment (LDI) is generally thought of as enabling schemes to bridge the gap in funding levels via the use of leveraged derivatives for hedging and growth assets to close deficits. In addition, cashflow requirements for DB pension funds are increasingly coming into focus.
There is significant regional divergence in the use of LDI strategies, with Invesco’s recent Global Fixed Income Study showing over 90% of the EMEA defined benefit pensions fund participants currently implement an LDI strategy compared to less than 60% for all Non-EMEA participants. EMEA investors have been at the forefront of LDI strategies, in part due to the better funded nature of DB pension funds in Europe relative to Asia Pacific and North America, rapid increasing maturity, and regulatory frameworks that encourage matching and mark-to-market valuations to reduce short-term volatility.
However, cashflow requirements for DB pension funds have come increasingly into focus as funding levels have improved. A recent asset allocation survey conducted by Mercer showed that around 56% of UK DB plans are already cashflow negative and the proportion of plans with a de-risking target of less than five years has almost doubled from 13% to 24% since 20181.
DB pension funds are increasingly looking at their ability to meet liability cashflows. From Invesco’s recent study, for those schemes with funding levels below 80%, the confidence level they have in their ability to meet cashflow requirements was below 50%2.
The term cashflow-driven investing (CDI) has been used to convey a range of approaches but can give the impression of being something entirely separate from current strategies. The term CDI gives the impression that the primary decision-making tool is narrow matching of cashflows as they fall due. In reality, investors are becoming more aware of cashflows themselves as well as a trend towards de-levering synthetically hedged LDI strategies into physical assets where possible. This approach therefore involves investment in those physical assets that can generate income that can be used to meet scheme cash outflows whilst at the same time aiming to produce attractive returns.
Current use of cashflow conscious strategies is relatively low, especially in comparison to the use of leveraged derivative-based LDI strategies. Invesco’s recent Global Fixed Income study showed that 50% of respondents that do not currently utilise a CDI strategy intend introducing one as funding levels improve3. However, 45% of participant funds highlighted the reason for not using a cashflow based strategy was due to unfamiliarity with these strategies in general4.
Introducing a cashflow focus to LDI
Funds previously have met cashflow needs from three traditional sources, contributions from employers or employees, investment income and sale of assets. However, schemes are seeing challenges in today’s environment especially as schemes mature and deficit contributions reduce.
Many investors are chasing similar longer-term contractual assets, ultimately driving up prices. UK pensions schemes, unlike insurers, are not constrained by the same regulatory requirements and are therefore in a position to use a wider toolkit compared with insurers when choosing investments. The caveat to this freedom is to be aware of the time horizon until buyout (full or partial) in order to have suitable assets for transfer to an insurer at the right time.
Implementing cashflow focused strategies
There is a misplaced appeal of having a close cashflow matching strategy (one that generates sufficient cash flows to successfully meet future liabilities). The use of close cashflow matching beyond 5-10 years becomes progressively less important as both asset and liability cashflows become more uncertain. Therefore, a manager that can continuously monitor, improve and more actively manage a range of income sources should be able to deliver a better outcome than a narrow 'buy and maintain' strategy in a limited range of assets.
By moving away from traditional fixed income assets there are several different tools that can be used to deliver on the need for cashflows whilst diversifying the source of income.
The inclusion of private credit assets in a cashflow focused portfolio can provide an increase in yield from the liquidity risk premium as well as diversification benefits. These characteristics provide support for increasing allocations to these types of assets within a CDI strategy as a supplement to more liquid buy and hold.
Flexibility in the types of real estate assets utilised can improve overall performance versus a narrow focus on certain long lease types which can become overbought (e.g. a hotels fund Investing in high quality core locations can provide long-term stable income).
Other income generating strategies can be utilised and further diversify from pure contractual assets for example, it is possible to generate an attractive income through relative value ideas e.g. exploiting interest rate differentials of one bond market relative to another using derivatives.
Clearly it is helpful for schemes to partner with providers who are able to access a broad range of strategies and can integrate them effectively with existing LDI mandates.
- 1 Source: Mercer European Asset Allocation Survey 2018.
- 2 Source: Invesco Global Fixed Income Study 2019.
- 3 Source: Invesco Global Fixed Income Study 2019.
- 4 Source: Invesco Global Fixed Income Study 2019.
- The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
- The opinions expressed are those of Invesco Investment Solutions team and may differ from the opinions of other Invesco investment professionals. Opinions are based upon current market conditions and are subject to change without notice. Performance, whether actual, estimated, or back-tested, is no guarantee of future results. Diversification and asset allocation do not guarantee a profit or eliminate the risk of loss. Unless otherwise stated, all information is sourced from Invesco, in CHF and as of March 31, 2019.