Feature
With just 14% of UK defined benefit (DB) pension schemes open to new members and future accrual, cash-flow has become a focus for the other 86%. Some 1.2 million pensioners are in schemes that receive no new money, The Pensions Regulator said in November, with just 11% of
UK scheme contributing.
An astounding 41% of all DB pension scheme members are drawing benefit, according to the regulator, with 48% deferred, meaning that they could request regular payments at any time. This means pension schemes need to gen- erate a regular cash income to pay these members rather than just recycling new contributions.
A couple of years ago, after looking at this increasingly mature UK pensions land- scape, some fund managers and consult- ants turned to the insurance market for inspiration. Annuity providers and other insurance companies need regular cash- flows to make agreed, regular payments, but do not receive regular contributions. Instead they use a cash-flow driven invest- ing (CDI) approach to ensure they can meet their payments and hold a range of low-risk fixed income securities that fall in line with their regulatory requirements. With pension funds needing a similar cash- flow profile, it might have been thought that they would happily follow that route too, but it has not turned out that way – at least not yet.
READY FOR ACTION?
The fly in the ointment is that most UK pension funds are not in a position to lie back and begin their final act. Just 3% of schemes were in wind up in November, according to TPR, accounting for just 52,547 members. For the rest of the schemes closed to future accrual, despite being fairly sure of whom they need to pay and for how long, there is an additional, somewhat bigger fly. At the end of December, some 3,271 UK schemes were in deficit on a buy-out basis, according to the Pension Protection Fund (PPF). This meant just 40% of the schemes
members actively
eligible for entry into the lifeboat had enough assets to push them through to the end. For the 60% that find themselves under water, they are at least one step away from setting up a cash-flow matching invest- ment strategy, which relies heavily on fixed income rather than growth assets to close any gap. But even for the 40% that could potentially consider the approach, few have been willing. Even the PPF, which was 123% funded at its last reporting period that ended in March 2018, does not run a CDI strategy, accord- ing to chief investment officer Barry Ken- neth. Instead, an in-house liability-driven investment (LDI) strategy manages the eco- nomic risk of future cash-flows. “CDI is a cash-flow matching strategy and
of derivatives, including swaps, CDI strate- gies are usually not created using leverage. This means the whole portfolio must be dedicated to one end goal, using up its entire firepower.
While investment grade and government- issued bonds are often preferred, real estate and infrastructure can give a steady enough return to meet cash-flows. However, unlike an LDI strategy, which tra- ditionally has a growth and matching port- folio running alongside, should a signifi- cant part of this CDI portfolio default, there are no growth assets left to take the strain and sweat a little harder to make up the gap.
There have been suggestions that just a slice of a pension that was linked to a sec- tion of scheme members – retired or
While your cash-flow needs might
be between 2.5% and 5% of your overall portfolio, the collateral calls on an LDI portfolio could be 20%. Alex White, Redington
thus your assets would have to be fully invested in fixed income,” Kenneth says. “In order to implement this across the whole fund efficiently, the return hurdle of the pension scheme would have to be the same or higher than the yield on the portfo- lio of bonds/cash-flow instruments to have enough money to pay the cash-flows.” From a portfolio construction perspective, there may need to be some compromises made when juggling diversification of sec- tor exposure and matching cash-flows. For example, long-term inflation-linked cash- flow issuers can be very sector-concentrated. Utility companies and banks are big issuers of these securities, whereas other sectors prefer rates set by the market. Unlike LDI funds, which match invest- ments up to specific liabilities to be con- verted or sold to create a cash-flow at a cer- tain date and can be created using a range
28 March 2019 portfolio institutional roundtable: CDI
deferred – could be managed on a CDI basis. But this increases the governance needed to oversee a strategy that sounds a lot like a partial buy-in or annuity that an insurer could do (albeit at a cost).
THE NAME’S BOND A reliance on bonds causes other barriers for CDI enthusiasts. Alex White, head of ALM research at Redington, says that there are difficulties in the details of cash-flow matching. “For example, if you want to buy a large, diversified, liquid investment-grade credit portfolio you may struggle to do so purely in sterling,” he adds. “For context, in the UK there is around £400bn in investment-grade bonds. There are close to £2trn in pension liabilities.” Instead, pension fund investors may need to look further afield, to the biggest corpo-
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