Cover story


In Lewis Carroll’s 1871 novel Through the Looking Glass, the protagonist Alice climbs through a mirror to find herself in a strange world where, just like the reflection of the mirror, logical connections are reversed. Alice finds that running helps her remain stationary and walking away from some- thing brings her closer to it. It is perhaps not surprising that the author of the famous children’s novel had a background in mathematics. Both Through the Looking Glass and its pre- quel, Alice in Wonderland, contain an abun- dance of metaphors to the world of mathe- matics which could be constructed as a criticism of the emergence of abstract alge- bra which is not tied to arithmetic or geom- etry.


Alice’s predicament bears some


resemblance to the slightly more mundane world of defined benefit (DB) schemes attempting to navigate their cash-flows in the current fixed income landscape.


LOOKING FOR CERTAINTY Cash-flow negativity has become a pressing concern for DB schemes. The number of UK schemes which pay out more than the contributions they receive increased to 73% from 66% last year and the majority of schemes that have a surplus of cash expect this to change in the next 10 years, accord- ing to Mercer’s asset allocation survey. With the endgame in sight, self-sufficiency appears to be the most popular target for DB schemes, as a recent survey of trustees and consultants by AXA IM indicates. This corresponds roughly to the share of schemes who are already using a cash-flow driven investing (CDI) strategy (52%), while an additional 21% are planning to introduce such a strategy in the next 12 months, a potentially significant increase. Louis-Paul Hill works as investment con- sultant for Aon, where he leads the cash-


flow management and endgame team. He challenges the perception of CDI as a con- sistent strategy as such. “I don’t use the term CDI because it can mean different things to different people. There isn’t really a clearly defined concept of it,” Hill says. “It could mean simply having a robust policy to pay your cash-flows however you invest. It could mean investing heavily in contrac- tual bonds such as corporate and high


poration, which runs its own CDI strategy but is able to do so by only taking on well- funded schemes. Moreover, investing in long-dated bonds or relatively illiquid assets requires a long- term horizon, as Julien Halfon, head of pension solutions at BNP Paribas Asset Management, warns. “Time is the crucial variable here. If you can be patient, if you can invest for 10 to 15 years, you can harvest


It would be more problematic to see


non-contractual cash-flows from assets such as equities being part of an explicit cash-flow portfolio. John Atkin, M&G Investments


yield. It could also be investing in buy-and- maintain


investment-grade credit or it


could mean investing so that you get the income to match your cash-flows.” This ambiguity makes CDI trends impossi- ble to analyse. Pension schemes tend not to indicate clearly which percentage of their portfolio is the cash-flow driven element and surveys such as that conducted by AXA IM contain a subjective element. In the absence of a clear definition, respondents might say they are pursuing a CDI strategy because they have increased their allocation to private credit or infra- structure. It could also mean increasing exposure to corporate bonds. Instead of a set strategy, cash-flow driven investment could perhaps be more mean- ingfully understood as a desired outcome, a situation where a schemes’ income and principal receipts are aligned to their liabil- ity cash-flows. But such a strategy comes with constraints. In the first instance, investors have to be prepared to sacrifice higher returns to obtain a greater degree of certainty, which means that the strategy is only suitable for relatively well-funded schemes. One exam- ple of a scheme which has pursued this successfully is the Pension Insurance Cor-


30 | portfolio institutional | October 2019 | issue 87


the illiquidity premium. If you have five years, it is not always going to work. You will have to be in highly liquid assets which will be acceptable to a buy-out firm. This typically means gilts.


“That is going to require a lot of contribu- tion from the sponsor,” Halfon says, and most DB schemes do not have an awful lot of time. About 30% have set themselves a time- frame of up to five years to de-risk, 38% are planning for between five and 10 years and only 6% are looking at a timeframe of more than 15 years, according to Mercer’s Asset Allocation Survey. Consequently, bonds are likely to play a growing role in an investor’s endgame planning. But they might soon find themselves running out of options.


BEWARE THE JABBERWOCK While UK investment-grade corporate bonds still offer positive yields, the uni- verse is limited to less than half a million such assets. Moreover, a record number of these bonds are already BBB-rated and could potentially be kicked out of the investment-grade universe, as Madeleine King, co-head of pan-European investment grade credit, warns. Therefore, investors will need to look increasingly at other mar-


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