Jonathan Crowther and Sebastien Proffit say schemes need to prepare their portfolios to deal with increased cashflow requirements.
Historically, trustees have met benefit payments from a combination of contributions and asset sales. At present, the cashflow requirement is likely to increase more than most are expecting - 42% of schemes are already cashflow negative with that figure expected to increase to 70% over the next five years1.
However, only 9%2 of schemes view managing cash flows as a key priority, with around four out of five schemes preferring to meet cash calls with asset sales. This will lead to an increasing risk of making the scheme a forced seller in depressed markets and is unlikely to be the most efficient approach, as highlighted recently by The Pensions Regulator3.
Similarly, seeking additional contributions can prove tricky for companies that have already poured substantial amounts into schemes through deficit recovery plans.
How can schemes improve the cash flow delivery?
One potential source of cash flow is income generated from the scheme's existing assets4. While these and other 'real' assets (e.g. long lease property and infrastructure) can be useful to meet part of the cash shortfall, unless the portfolio has been constructed with income in mind, these assets may not generate sufficient income.
Corporate bonds are particularly well suited in helping trustees meet their near-term cashflow requirements without requiring forced asset sales. Using certain5 coupon and maturity payments from the bonds can help schemes close deficits as returns can exceed those on gilts.
Management of the default risk is crucial; long-term thematic analysis alongside fundamental and relative value analysis is needed when assessing the default risk of any bond. In many ways schemes have to start investing like insurers.
Larger schemes with segregated portfolios have started to focus on cash flow management as another key parameter. However, to date it is not easy for smaller schemes to do so. This is driving the development of new, simple and cost-effective cash flow delivery pooled funds.
These strategies are designed to deliver expected cash flows by holding a diversified portfolio of corporate bonds while minimising defaults. Seeking to ensure defaults are minimised, the bonds are selected to provide the target cash flows through expected coupon payments and maturity proceeds as well as generate a return above government bonds.
The cashflow challenge should be addressed in a holistic manner
While we believe cashflow delivery will be the next big challenge for pension schemes, we recognise that deficit recovery and liability hedging remain key to meeting schemes' objectives. Pension schemes can adopt the following techniques to improve their cashflow delivery while seeking to reduce their deficit, so stabilising their funding position.
- Credit optimisation
Typically UK pension schemes have held long duration UK corporate bonds to achieve some interest rate protection. By removing the need for corporate bonds to provide interest rate protection and allowing greater global exposure, it is possible to boost both expected returns (e.g. by holding some dollar credit) and cash flow generation (e.g. by holding shorter dated bonds) while improving the risk and diversification characteristics of the portfolio.
- Liquidity management
Combining credit and liability driven investment (LDI) can also help address the timing mismatch between monthly pension payments and the 'lumpy' receipts from bond coupons and maturity payments. This can be achieved by using some of the typical LDI techniques to provide cash in the period between pensions being paid and bond proceeds being received.
Where schemes have passive physical equity portfolios alongside credit it is also possible to improve cash flow by gaining equity exposure using derivatives so releasing around half of the physical assets to invest in corporate bonds. This efficient use of capital would typically boost the expected return on the total value of equity exposure by up to 0.5% p.a.
- Collateral efficiency
Adopting an integrated approach to credit and LDI offers a further opportunity to add value. Where the two portfolios are held by the same manager, less cash and gilts need to be held in the LDI element provided that, in the event interest rates rise substantially, the corporate bonds can be readily converted into collateral. This can allow a scheme to reduce their strategic allocation to LDI collateral by 10-20% further increasing cash flow and boosting the expected return by c.1% p.a. on any assets reallocated to the credit portfolio.
In summary, we believe now is the time to start preparing a more integrated approach to this new challenge as the move to cashflow negative is an inevitable outcome for most schemes in the coming years.
Jonathan Crowther is head of UK LDI and Sebastien Proffit is head of portfolio solutions, fixed income at AXA Investment Managers.
Source 1: Mercer European Asset Allocation Survey, 2016
Source 2: Hymans Robertson Trustee Barometer - January 2017
Source 3: The Pensions Regulator: Annual funding statement, May 2016
Source 4. Including coupons from corporate bonds, dividends from equity and rent from property
Source 5. This is provided that the bond is held to maturity and the issuer does not default.
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