Ian Barnes looks at how schemes can tackle cash flow negativity
For many schemes gaining a balance between matching long-term liabilities, achieving sustainable growth and generating a stable cash flow presents an investment and governance challenge. Our proprietary research suggests that pension schemes are adopting a more piecemeal approach regarding the third issue, tackling the looming problem of cash flow negativity.
Pension schemes have attempted to control future liability growth through closing schemes. This means they no longer receive regular contributions, which previously had acted as a source of regular cash flow. The reduction in the public sector workforce has seen contributions decline rapidly in Local Government Pension Schemes too.
The increased lifespan of pension members means that the pension pot needs to go further. Pension funds have found themselves becoming cash flow negative just as increasing numbers of members have begun to retire, placing greater demands on the need for cash.
Some pension schemes have recognised this trend, but the methods employed for dealing with this issue can exacerbate any existing funding gap. Schemes may utilise a cash balance to meet near-term cash calls. But with cash rates at historic lows, this cash allocation returns very little, particularly when factoring in inflation, and can prove to be a drag on portfolio performance.
Another solution has been to draw down investments to fund near-term cash needs. The decision about what asset to sell, when to sell, how to avoid expensive transaction costs and effectively becoming a forced seller can present a huge governance burden.
Utilising dividend income from existing investments can present a similar governance challenge. The impact on growth should not be underestimated as it is the compounding power of dividend re-investment which has historically helped drive equity returns.
Investors may consider that an LDI programme offers cash flow matching characteristics, however the underlying instruments can be illiquid. These programmes are usually aimed at matching longer-term liabilities, so pension schemes may wish to consider what a suitable cash flow solution could entail.
Embracing a new approach - cash flow
A cash flow solution should provide a return profile which is predictable and frequent. The underlying asset should be readily realisable in the event that the cash flows it produces are insufficient to meet the immediate liability and should have some degree of capital stability.
Equities may offer a number of desirable characteristics for pension schemes such as the opportunity for capital growth, potentially higher cash flows which may grow in line with inflation and carry little reinvestment risk. Equities may not, however, provide the most reliable source of income.
Short duration fixed income offers schemes a number of the desirable characteristics of a cash flow solution but at the cost of any opportunity for capital growth, and with the prospect of lower yields could be negative after the impact of inflation is taken in to account.
By buying longer dated fixed income instruments or bearing credit risk and buying lesser credit quality issues, the size of the cash flow earned will increase but investors need to be mindful of the additional risks they would be bearing in these circumstances.
Exposure to default risk means there is no guarantee that an investor would maintain the nominal value of their investment even if they were able to hold it until maturity.
Although some real assets such as property can provide excellent sources of long-term income, in reality no single asset offers a panacea for the challenges that face UK pension funds. A combination of different asset classes may be more appropriate and could help pension schemes stave off cash flow negativity.
The governance challenge
A consequence of expanding the range of asset classes is the increased governance burden placed on scheme trustees. Trustees have to contend with a potentially greater number of managers and ensure these managers are making a positive contribution to the scheme's overall objectives.
Balancing the requirements for growth, matching long-term liabilities and achieving a stable cash flow presents both an investment and governance challenge. Add to this the increasing range of considerations schemes must factor into their asset allocation strategy and it is clear that UK pension schemes are facing an increasingly complex world. Pension schemes should therefore consider the full range of options at their disposal in order to meet their long-term objectives.
Ian Barnes is head of UK & Ireland, UBS Global Asset Management
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