Industry Voice: A deeper look at how M&G Investments has managed its own annuity book for its insurer parent reveals the lessons learned when matching cashflow liabilities over time, an ever-increasing challenge facing pension funds.
For Investment Professionals only. The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested.
For many pension schemes and trustees, the ever-more pressing challenge is not only meeting cashflow liabilities now, but into the future. Planning to pay out the right level of cash at the right time not only creates challenges in terms of generating the level of cash necessary, but also in how to weather changing market dynamics to deliver these required cashflows over the long term.
This is an issue that affects a vast number of schemes. According to the Mercer European Asset Allocation 2018 survey, six out of ten plans surveyed last year were already cashflow negative and, of those that were not, eight in ten expect to become negative within the next ten years. The benefits of having a plan to meet liabilities is clear, as Hymans Robertson estimated that forced selling of assets is likely to cost UK defined benefit schemes £250 billion.[1] This is based on modelling a downside scenario for typical scheme portfolio of equites and gilts against an alternative portfolio focused on cashflow risk and the subsequent funding level progression. The alternative portfolio benefits from not having to sell assets when they fall in value.
Some schemes can consider a fully insured buy-out, but this is often unaffordable. Even when buy-out and buy-in has become cheaper, there has not always been a corresponding change to the underlying bond rates, leading some to question how reliable those guarantees actually are. Therefore, aiming for self-sufficiency by matching cashflows over time could be a solution. After all, a healthy, self-sufficient scheme can always consider insured options at a later stage.
Building a bespoke annuity book
The approach of matching cashflows to liabilities as they fall due is similar to how an annuity book is run, which is one of the reasons that many pension schemes have been asking how our own annuity book, managed for our insurer parent, has delivered over decades. What have been the building blocks we have used, and the lessons learned over time?
We believe it necessitates being flexible and asset-agnostic, as well as being patient and disciplined when building a portfolio.
Primarily using physical assets to match liabilities can help a scheme to reach a different kind of certainty, rather than hedging risk via swaps alongside a growth portfolio. Exposure to physical assets, such as through secured debt, can offer another way to address some of the risks that are met with traditional LDI portfolios, such as interest rate risk. Infrastructure debt, for example, can offer long-dated cashflows, with debt being repaid over 20 to 30 years, while they are usually inflation-linked and predictable, with contracted payments often derived from well-regulated entities.
Another example of physical asset exposure is through long lease real estate, which offers bond-like cashflows from a long-term lease on property. Such income streams are again often inflation-linked, while also offering the potential for capital gain from ownership of the property.
Predictability in cashflows is a feature that lends itself to a cashflow matching portfolio and flexibility to access both public and private financing can allow schemes to, in effect, build their own bespoke, commercially-efficient annuity book. Every asset selected for inclusion fulfils a specific task.
Asset in focus: Alder Hey Children's Hospital, Liverpool, UK
M&G Investments provided funding for the redevelopment of Alder Hey Children's Hospital
Annuity-like repayment profile provides stable cashflows from the NHS trust
Conservative covenant package provides lender protection
Structure provides credit support and additional security
Flexible and asset agnostic approach
Why is a flexible and asset agnostic approach necessary for a cashflow matching portfolio? The first reason is risk mitigation: just adding more credit risk is not a solution to generating reliable cashflows. It's important to buy a broad diversity of assets, where the risks to cashflow interruption are well-rewarded. A portfolio should reflect an individual scheme's trade-off between return, risk and liquidity to meet a scheme's specific cashflow needs. That's why we focus on creating bespoke solutions that adapt to different liquidity requirements through the life of the scheme.
The second reason is that value shifts as markets evolve, which is why all cashflows do not need to be matched at once. To achieve such flexibility, we keep some powder dry to access cashflows as they become cheap. This is reflected in the fact that our own annuity books look very different from how they did 15 or 20 years ago.
By taking a strict value-based approach, underpinned by extensive bottom-up credit research, we can work to not only ensure pension payments are met, but also to de-risk schemes. Putting into practice considerable resource, patience and discipline is the approach we have used to manage both our own annuity books and cashflow-matching portfolios for external clients.
Efficiency is key when building a bespoke annuity book that needs to evolve over time. This means not paying up for liquidity that is not needed in the short term. By broadening-out asset origination to capture, for example, illiquid opportunities that could generate higher cashflows, some powder can be kept dry to capture value should it emerge. Taking such an asset-agnostic approach can aid portfolio diversification and help achieve both de-risking and the required cashflow that is the ultimate goal for a pension scheme.
For Investment Professionals only.
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[1] Based on modelling from 2015-2038.
