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CASH IS KING FOR DB PENSIONS
Strategies focused on generating income need to be a key feature for DB pension funds in 2020 and beyond.
Norbert Fullerton
Head of institutional client strategy, EMEA Janus Henderson Investors
The changing landscape In 1998, one of my first tasks when I entered the actuarial profession was to work out the level of defined benefit (DB) pension fund surplus that could be refunded to the sponsoring employer or shared with members via uplifts to their pensions. Those were the good old days when most pension funds were open to new members. Today, the DB pensions landscape has changed dramatically. Most DB pension funds are closed, have increased in matu- rity, have huge deficits and are focused on managing various risks associated with their sponsor, assets and liabilities. Fund- ing levels have also improved since the nadir of the global financial crisis, thanks to the last decade of deficit payments from sponsoring employers and a bull run in equity markets. Trustees and spon- sors have, therefore, shifted their focus towards conservative endgame strategies. Whether the endgame strategy is to achieve self-sufficiency (i.e. there is low dependency on the sponsor) or to transfer liabilities to a commercial DB consolida- tor, or buyout with an annuity provider, the challenges are the same. While fund- ing levels have improved, the vast majority of DB pension funds still need to become fully funded on a conservative measure, so that they can pay all members’ benefits when they fall due.
Why CDI? Shockingly, within 10 to 15 years, almost all DB pension funds will be cash-flow negative, meaning that they do not have enough income to pay their outflows, such as members’ benefits. To manage the cash-flow negative prob- lem, most DB pension funds are disin-
12 | portfolio institutional March 2020 | issue 91
vesting assets to pay pensions. That is not a sustainable solution. If they sell their assets at the wrong time, especially when market values are depressed, and their pension fund is in deficit, they could run out of money fairly quickly or need extra sponsor support.
Other pension funds have opted for their investment mandates to distribute income where possible. However, this is just a ‘stopgap’ because many of those mandates do not usually produce a suffi- ciently high level of income. The answer lies with a more optimal approach: it is imperative that trustees and sponsors refine their portfolios and adopt cash-flow driven investment (CDI) strategies that are tailored to their cash- flow requirements, allowing room for any uncertainties. That will help produce the income that they need – especially if their pension funds are already (or will soon become) cash-flow negative.
Key considerations In designing a strategy, three key ele- ments should be considered. The charts below show sample CDI strategies, which vary depending on endgame objectives. First, the endgame strategy. Each long- term funding and investment objective, including the current funding ratio on which they are based, and the respective timescale to full funding, should drive the design of the CDI solution. Second, the design. Any good CDI solu- tion must consider factors such as the trustees’ and sponsor’s risk appetite, liquidity needs and certainty of cash- flows. Most CDI strategies would com- prise assets with contractual cash-flows, such as government bonds and buy-and- maintain credit. However, especially if there’s a pension deficit, there should be appetite for assets that produce cash- flows with a high degree of certainty but may not be guaranteed. These could include
quality global equity income
assets that have low volatility and pay healthy dividends.
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