Kerrin Rosenberg says while the rise of CDI is positive, understanding the risk and return aspect is a great challenge
Cashflow-driven investing (CDI) has become one of the go-to tools for schemes tackling maturity challenges. But is this the miracle solution we've all been waiting for?
The short answer is ‘possibly' - but only for a small percentage of funds.
CDI has risen up the ranks for good reasons. Pension funds have grown increasingly mature and, generally, are now well into the decumulation phase. They are paying monthly to pensioners, so if they don't own investments that provide enough income, they must sell assets to finance monthly outgoings.
In the decumulation phase, funds can no longer merely target their required performance, on average, over a long period. Simply put, good returns tomorrow will not offset poor performance today, as some of the assets will have been sold to meet today's cashflow requirements.
Under a CDI approach, schemes create a purpose-built portfolio, specifically designed to provide the predicted cashflows required. Naturally, most CDI solutions are packed full of bonds and income-producing property assets.
It all seems so obvious, so what's the catch? There isn't really one but, like all investments, where there's a return there's a risk. Understanding the nuances of the risk and return aspects of CDI can be a minefield.
There is a huge choice of assets that could reasonably form part of a CDI programme. These range from vanilla investment grade corporate bonds, to more esoteric asset-backed structures. A good starting point is to evaluate candidate assets based on credit and liquidity risk.
When investing in credit, borrowers pay higher yields than gilts because there is a risk they will default. The greater this risk, the higher the yield they will pay. As an investor, the initial yield on credit instruments is visible, but you need to make an allowance for expected losses through defaults. A high-quality corporate bond portfolio would probably be expected to deliver gilts +1%, net of expected losses and management fees.
In terms of liquidity risk, private debt should give higher yields, but the assets aren't liquid. This loss of flexibility is a handicap, particularly for schemes aiming for buy-in or buyout. Even if this isn't the intention, it is far more difficult to dispose of private debt in the event of a deterioration in credit worthiness en route towards default. Private debt could yield 1%-2% more than liquid debt of an equivalent credit quality.
In practice, CDI usually sits alongside a traditional liability-driven investment (LDI) portfolio due to the difficulty in fully matching both the inflation linkage and duration of a pension fund with CDI assets alone. Assuming schemes would want to be hedged fully against interest rates and inflation, they would probably need to hold 10%-25% of assets in gilts to support the LDI programme. So in practice schemes are unlikely to be able to invest 100% of the portfolio in CDI.
What can schemes expect from an investment grade, liquid portfolio? Low-risk CDI is consistent with an expected return of gilts +0.75% to 0.9% (net of fees, downgrade losses and other risks).
Bear in mind technical provisions will need to shave a prudence allowance from this - so if schemes are (close to) fully funded on a gilts +0.5% basis, then a liquid, investment grade CDI approach makes sense.
Schemes must consider what suits them best: a CDI approach using large volumes of private debt and lower quality credit, or a diversified approach with a significant LDI portfolio and smaller allocations to diversified, illiquid growth assets. It's not obvious, and individual circumstances could be quite important in determining which route is best.
Finally, CDI doesn't have to be all or nothing. It could make sense to build up a CDI portfolio gradually as schemes progress towards their final destination.
Kerrin Rosenberg is UK chief executive of Cardano.
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