Credit where credit is due

More than half of the UK's defined benefit (DB) pension schemes are cashflow negative; a figure expected to rise to 83% in the next decade[i].

As plans close to future accrual and head towards maturity, outgoings will exceed income from investments and contributions.

In response, trustees and sponsoring employers are in search of strategies that allow them to meet their ultimate goal: paying benefits on time and in full.

Until recently, DB plans have often combined liability-driven investment (LDI) strategies which invest in government bonds (gilts) to manage risk relative to their liabilities, alongside return seeking assets to help plug funding gaps.

But as schemes have matured and funding levels improved to as high as 99.5% as measured by the Pensions Protection Fund in March 2019[ii], trustees want to reduce investment risk in their return seeking strategies.

A steady flow

A possible solution lies in cashflow driven investment (CDI) strategies, an approach already tried and trusted by insurance companies when matching their liability payments.

Much like LDI, CDI uses fixed income to provide certainty of cash flow to meet liabilities. But unlike LDI which matches liability profiles as closely as possible to gilts, CDI looks for credit assets that can deliver additional return over Gilts. The two strategies can be used in tandem to help pension funds meet future cash flow demands.

Hannah Simons, head of fiduciary management at Schroders, says: "Pension funds would only buy government bonds to meet their cash flows if this could meet their obligations. But funding shortfalls, mean trustees still need to fund extra return. CDI looks to fill that shortfall by using corporate bonds or credit instruments with contractual cash flows that promise higher returns than gilts."

Traditionally DB plans have relied on growth assets such as equities to deliver additional return. However, trustees have been subject to the vagaries of the stock market, often experiencing significant volatility.

Simons says CDI strategies provide far greater certainty of outcome compared to the traditional growth and matching approach.

"When we move into the CDI world, we are buying credit assets that provide some return but with a much narrower range of outcomes," Simons explained.

However, trustees are not able to give up volatility without a trade-off. Moving from equities to fixed income requires relinquishing some liquidity. However, Simons said CDI strategies invest in a range of fixed income assets with redemption dates that correspond with payment schedules. She also noted that CDI need not be a precise matching strategy.

She explained: "Liquidity is a key risk as schemes mature. When we design our CDI strategy, we give attention to the cashflow profile, but CDI is about being cashflow aware, rather than focusing on cashflow precision."

Building blocks

Finding suitable credit assets to meet cash flows is much easier today than pre-financial crisis. After the credit crunch, banks were far less willing to lend to the market. Pension funds emerged as natural lenders, while borrowers were keen to find new ways to do business.

Consequently, trustees have a wide array of assets from which they can construct a CDI strategy. Longer dated assets or buy and maintain investment grade credit, which include corporate bonds or infrastructure debt - are ideal CDI building blocks. The latter provides secure, inflation linked income which is ideal for meeting future cash flows. However, competition for these assets - both from other pensions schemes and insurance companies - can make them hard to come by.

Trustees can also choose from shorter dated, higher yielding assets - high yield debt, emerging market debt and insurance linked securities, for example. These may be less certain than the longer-dated options but have the potential to deliver additional return. As the scheme's funding level improves, the goal would be to reduce these higher returning credits in favour of more certain hold to maturity assets.

Simons gives an example of a scheme that is 95% funded today embarking on a CDI strategy with a view to buyout with an insurance company in ten years' time.

The initial CDI portfolio would comprise 30% matching assets in the shape of gilts and cash. Fifty-five percent would be invested in buy and maintain credit assets, while the remaining 15% would be allocated to higher yielding credit assets.

Simons said: "As the funding level improves and the scheme matures, the allocation to the higher yielding credit would diminish in favour of increasing allocations to buy and maintain assets. At the expected point of buyout, the scheme will hold only buy and maintain assets and gilts which mimics the insurers' strategies, making the scheme well placed to buyout. If the scheme continued to run in self-sufficiency, eventually the buy and maintain credit assets would give way to an entirely matched portfolio invested in gilts and cash"

CDI will not be suitable for every scheme. Immature schemes or those with more serious deficits will be less able to adopt this approach. However, as DB plans mature and funding levels improve, CDI strategies offer a real chance for trustees to return stability to the portfolio and provide certainty of the ultimate objective.