What is Cashflow Driven Investment?

Who it is appropriate for and what are the benefits/risks?

Cashflow Driven Investment strategies are increasingly being employed by defined benefit pension schemes as they approach the end-game. This is the first in a series of articles on Cashflow Driven Investment, starting with an introduction to the subject.

Executive Summary

A cashflow driven investment (CDI) strategy selects assets which provide contractual income to match, as far as possible, the future expected cashflow requirements of the pension scheme. By matching cashflows, the assets are intended to be held to maturity and so provide a greater level of certainty over return.

CDI has been employed by insurance companies to back their annuity books for a long time. Although pension schemes are not bound by insurance company regulations, CDI is increasingly being seen as an appropriate strategy to provide a stable, long-term and low-risk solution for a maturing scheme, reducing reliance on the sponsor.

CDI works best when integrated with Liability Driven Investment (LDI), particularly as cash low matching of long-dated liabilities with credit may not be possible at the outset or may be only partially affordable. LDI can also be used to provide inflation protection, where insufficient inflation-linked credit assets are available.

Although a “Buy and Maintain” style of investing is at the core of CDI strategies, reinvestment risk, liquidity risk, default risk and liability experience should be monitored over time with the strategy updated accordingly to ensure it remains fit for purpose.

Background

Many employers have shifted towards providing defined contribution arrangements for their workers. This has led to the decision to close their defined benefit pension schemes to new members and future accrual. As doing so results in a cut to the supply of member and employer contribution payments in respect of accrual (a principal source of income for the scheme), the net cashflow of many pension schemes has decreased materially. These closed and maturing schemes are also affected by the lump sum payments and transfers out available to members since the recent pension freedoms. The combination of these trends has led many schemes to be cashflow negative.

Being cashflow negative means that the amount paid out to members each year exceeds the amount the scheme receives in annual income from sponsor contributions and investments. Approximately 55% of UK schemes are currently cashflow-negative; this figure is expected to increase to over 90% within 10 years1 .

If cashflow-negative schemes do not have a plan in place, they will be forced sellers of assets over time. Being reactive means schemes are exposed to market conditions at the time of disinvesting, leading to unreliable outcomes. A cashflow driven investment (CDI) strategy aims to provide a solution to this problem as part of a holistic end-game strategy.

What is CDI?

A CDI strategy selects assets which provide contractual income to match, as far as possible, the future expected cashflow requirements of the pension scheme.

A CDI strategy selects assets which provide contractual income to match, as far as possible, the future expected cashflow requirements of the pension scheme.

A corporate bond, for example, offers a number of coupon payments along with a final redemption payment promised to the holder. These contractual cashflows are therefore predictable and can be used to match liability cashflows.

By matching cashflows, the assets are intended to be held to maturity and so provide a greater level of certainty over return. Government bonds and investment grade corporate bonds are typically considered as low risk assets, but the value (mark-to-market) can be volatile over time. However, within a CDI strategy, as the assets are not intended to be sold, the scheme is less concerned with the volatility of the value (mark-to-market) of the bond.

CDI has been employed by insurance companies to back their annuity books for a long time. Although pension schemes are not bound by insurance company regulations, CDI is increasingly recognised as an appropriate end-game strategy to provide a stable, long-term and low risk solution for a maturing scheme, reducing reliance on the sponsor.

Objectives of a CDI portfolio

A trustee’s primary objective is to ensure, as far as possible, that pension benefits are met as they fall due. A CDI approach aims to increase the probability of achieving this objective by explicitly matching future cashflows and therefore securing the return on the portfolio at outset.

Many schemes have traditionally been concerned with funding level and deficit volatility, and have implemented successful LDI strategies to reduce interest rate and inflation risk. This has provided more certainty over the level of sponsor contributions required to achieve full funding over time.

With CDI, the focus changes from hedging the value of the liabilities to cashflow matching. But CDI does not replace LDI. It works best when integrated with LDI. Cashflow matching of long-dated liabilities with credit may not be possible at the outset, either due to affordability constraints or due to lack of suitable assets. LDI can also be used to provide inflation protection, where inflation-linked credit assets are unavailable.

Advantages of CDI over traditional growth/hedging strategies

Allocating between growth and hedging assets to achieve an expected return target has been a successful strategy for many pension schemes. The growth allocation has provided strong investment returns since the financial crisis, while the matching allocation is used to reduce interest rate and inflation risk by investing in gilts or LDI. However, as a scheme matures, the growth assets will need to be sold down to meet cashflow requirements. This means the scheme will become sensitive to market conditions at the time of disinvestments.

Also, cashflow negative schemes employing a traditional growth/matching strategy become more sensitive to potential falls in growth asset values. In later years, higher percentage returns are required to recoup the initial loss compared with a more immature cashflow positive scheme.

By matching future cashflows, or a subset of future cashflows, by using CDI, disinvestment risk is significantly reduced compared with a typical growth/matching strategy. Hence, return is more certain.

A scheme’s CDI strategy can be integrated with the funding approach to provide lower funding level volatility.

Who should use CDI?

CDI is appropriate for most schemes of all sizes considering or approaching the end-game.

CDI is appropriate for most schemes of all sizes considering or approaching the end-game. Two key indicators that CDI may be suitable are:

  • Mature (closed to new entrants and accrual)
    • Cashflow negative
    • Looking to reduce reliance on the sponsor
  • Reasonably well-funded on a low-risk basis

Typically a scheme will need to be reasonably well funded to implement a full CDI strategy since the types of high quality contractual income assets currently available have lower expected return than traditional growth assets. Therefore, a complete CDI solution may not be suitable for an underfunded scheme requiring a high investment return to fill the deficit gap.

However, for schemes unable to implement a full CDI strategy due to funding constraints, partial CDI strategies can be employed to build up the level of cashflow matching over time as the funding level improves. For example, the more certain liability cashflows expected over the next 10-15 years could be matched initially, combined with an allocation to growth assets to boost expected return. Here the growth assets, in combination with LDI, would target the longer-dated liability payments. As time passes, and the funding position improves, an ever-greater proportion of the liabilities can be cashflow matched.

As part of an end-game strategy, some schemes are targeting buyout with an insurer. CDI can be an appropriate strategy to reduce risk in the run-up to the buyout. Due to the overlap with how insurers invest, at the time of buyout, some liquid CDI type assets can be attractive to insurers and lead to in-specie transfers. This can reduce transaction costs which otherwise would be borne by the scheme.

CDI can also provide an alternative ‘self-sufficient’ approach instead of buyout. Often, it can provide an expectation of meeting all the pension benefits at a lower overall cost than full buyout.

What types of assets would be included in a CDI strategy?

There is a wide range of contractual income assets which could be incorporated within a CDI strategy offering different yields and levels of risk. The assets selected within a CDI strategy will depend on the return requirement. A better funded scheme will require less investment return and therefore be able to invest in lower risk assets e.g. government bonds and investment grade corporate bonds.

However, if additional returns are required, less liquid assets, such as private debt can be incorporated to take advantage of the illiquidity premium while still providing contractual cashflows to match future liability payments.

Overseas assets may be incorporated within the strategy, particularly to match longer dated liability cashflows where UK assets are unavailable or lack diversification. This can be combined with currency hedging to provide more certainty.

Combining CDI with an LDI strategy is likely to be required for longer-dated liabilities and inflation, where credit assets are unavailable.

Risks of CDI – things to watch out for

Long-dated liabilities cannot always be cashflow matched with credit at outset due to the limited availability of long-dated credit assets. Gilts could be used to match long-dated cashflows, but schemes may not be sufficiently funded to employ this approach. Therefore, there will often be some element of reinvestment risk in the future as credit assets become available to match longer-dated cashflows. This should be acknowledged with a prudent assumption for yields at the time of reinvestment when designing an appropriate strategy.

A bond held to maturity will provide promised cashflows unless the issuer defaults. The level of default risk typically is compensated for by a higher yield but can vary considerably across asset classes. Diversification to ensure the scheme is not significantly exposed to any one issuer is important, as well as making an allowance for defaults when designing a strategy. Where potential default might be correlated with a weakened sponsor covenant, this should also be taken into consideration e.g. certain industrial groupings of bonds.

The level of future pension payments cannot be known with certainty and depends on experience over time e.g. longevity, levels of transfers out etc. Therefore, CDI strategies should be monitored and updated over time to allow for experience. Combining CDI with LDI can provide flexibility to raise additional cash through gilt repo if required e.g. when cashflow requirements are unexpectedly higher than income from CDI in any given year. Segregated LDI portfolios provide more flexibility in this area than pooled funds.

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.