Author: Lionel Pernias
Pension funds, struggling with funding levels, can benefit from adopting a cashflow driven investment strategy, as they look to meet their commitments to members, argues Lionel Pernias
The trend of cashflow negativity
2020 has been a year full of surprises and unexpected events. Covid-19 has caused unprecedented volatility, leaving many pension schemes considering the potential impact to their endgame plans.
While Covid has impacted pension schemes in the short term, the last three-to-five years has been dominated by a different trend which has seen maturing defined benefit (DB) pension schemes grapple with cashflow negativity, and therefore put greater emphasis on how they are going to meet their member promises.
More than half of UK pension schemes are currently cashflow negative - 73% according to Mercer - with this figure only set to grow as more and more schemes close to future members and naturally mature.
Shifting to cashflow driven investment (CDI) strategies
Against this backdrop, we have seen a considerable shift in focus to the concept of cashflow driven investment (CDI) strategies, which aim to help schemes increase certainty over their ability to meet both their future cashflow requirements and their funding objectives. Over the last three years, CDI strategies have experienced a rise in demand not seen since liability driven investing (LDI) rose to prominence in the late-2000s.
At its core, CDI aims to help those schemes transitioning from accumulating funds and liability management in the growth stage, to meeting cashflow demands as their member promises fall due.
A CDI strategy’s focus is on reducing the need for schemes to become forced sellers of assets, which can result in larger transaction costs and higher required return target in the future. It allows schemes to plan for their cashflow requirements using liquid and buy-out-friendly instruments such as corporate bonds. Crucially, CDI not only focuses on acquiring these instruments, it also seeks to restructure schemes’ existing assets to ensure they are focussed on cashflows while also contributing to return generation. In effect, CDI strategies concentrate on the timely provision of cashflows in order to limit capital drawdowns.
Many UK pension schemes are already well placed to make the switch to distributing cashflows, as a major part of a typical pension scheme’s portfolio will be in fixed income assets such as corporate bonds. Liquid assets, such as corporate bonds, also provide the flexibility for schemes to remain open to a range of end game outcomes or to lock into further cashflow certainty when attractive market opportunities become available.
Given the long-term tenure for which schemes will likely be holding these bonds, deep-dive fundamental research plays a huge part in developing and maintaining a sustainable CDI strategy.
The investment process must accordingly reflect the difference in time horizon; incorporating long-term strategies and overarching trends at the name and sector level, as well as – crucially – non-financial considerations such as ESG criteria.
By incorporating these factors alongside deep credit analysis, schemes can look to mitigate against downside risk and the potential impact of market shocks and defaults, of which we have seen multiple times this year.
While we believe it is important that CDI strategies are not limited to purely credit, it can be a key building block alongside gilts and other higher yielding assets for schemes looking to strengthen their funding levels and match long-term liabilities. However, while credit brings a greater certainty of cashflows and a lower risk profile than equities, there are specific factors to consider.
One key issue is supply. UK pension scheme liabilities currently stand at £2trn and, while there are plenty of gilts available for schemes to use, other Sterling assets are in shorter supply. This supply/demand imbalance can create a sourcing issue for managers, and with the trend towards CDI strategies rising, this is only likely to increase.
For these reasons, more recently and over time we would expect most schemes to widen their investment universe beyond both Sterling and traditional credit markets. For example, we expect to see core Sterling holdings complemented by overseas credit, collateralised loan obligations, short dated high yield and less liquid investment solutions that offer higher yields.
The impacts of Covid
Covid has had a big impact on the world economy and we have seen companies struggle in some sectors. Pension funds have had to look at what risks they are exposed to, and take into account how to best minimise long-term losses.
For example, following the peak of the crisis, schemes could have looked to sell down some parts of their growth portfolio to take advantage of a 50-75 basis point premium on the purchase of long-dated investment grade credit, relative to their pre-crisis spread levels. Given the long-term nature of these assets, these gains are being locked in for potential 20-30 years, which would materially support schemes in achieving their long-term objectives.
Given the volatility being seen across markets it’s vital to ensure that schemes have a robust hedging programme in place across the portfolio. Where you may have separate CDI and LDI managers, it’s important that they work together to ensure this is being monitored on an ongoing basis to control any out of market risk or challenge to the hedging solution.
What's on the horizon?
Looking forward, regulation and more industry focus on ESG are going to play a huge part in the next five years for pension schemes. We have already seen tougher guidelines proposed by The Pensions Regulator for the DB funding code, and the ongoing shift in demand for more ESG-friendly investments is only going to continue as investors see the risk and return benefits of integrating these factors into their investment strategies.
We believe that against this backdrop and regardless of the eventual endgame, using a CDI strategy, alongside a LDI strategy to minimise drawdowns exacerbated by cashflow negativity, can only be beneficial to schemes in the long run to be able to meet member promises.
Lionel Pernias, Head of Buy and Maintain London - Fixed Income - AXA Investment Managers