Sponsor’s position paper by John Dewey, Aviva Investors
With many pension schemes becoming cashflow negative, an increased focus on income generation and cashflow management is required. Given that insurers have been facing the same challenges for many years, what can be learnt from their experience?
Defined benefits pension schemes face a myriad of challenges. The low bond yield environment, coupled with the heightened volatility of growth assets, such as equities, means that strategic investment decisions around liability hedging, tactical and strategic asset allocations are tougher than ever to make.
These challenges are further compounded for a growing number of pension schemes that are close to, or are becoming, cashflow negative, i.e., they are paying out more in pensions than they receive in contributions. Half of FTSE350 schemes already fall into that category, paying out £13bn a year more than they receive in contributions, a figure that is set to rise to £50bn by 2030.
In particular, the decisions around cashflow management and income generation should be factored in to avoid situations where pension schemes become forced sellers of assets to meet any shortfalls. Although cashflow negativity is a new challenge for an ever-growing number of pension schemes, insurers have been managing their assets on this basis for many years with the focus on income generation and robust risk management.
How do insurers invest their assets?
Out of all the different types of insurers, the liabilities facing an annuity provider most closely represent those incurred by a pension scheme. An annuity provider structures an investment strategy that hedges and closely matches liability cash flows. The overarching objective is to ensure that all the pensions are paid while enough profit is generated to cover longevity risk, pay ongoing costs and deliver a profit for shareholders. A typical annuity provider will structure its portfolio to invest in income-generating assets with a derivatives overlay to hedge out any remaining interest rate and inflation risk. The entire portfolio is managed on a ‘buy and maintain’ basis with the objective of matching and beating the liabilities, unconstrained by any benchmark indices.
What can pension schemes learn from this approach?
There are lessons that pension schemes can learn from the insurer’s approach. In particular, for schemes that are, or are about to become, cashflow negative the following steps could be taken to improve their investment strategies:
1. Make extensive use of alternative income and credit assets – The assets that can be used for cashflow management and predictable income generation purposes still form only a modest proportion of most pension scheme portfolios. Traditionally, pension schemes have invested in gilts and some also used LDI to target their liabilities. To make the most of the insurer approach, pension schemes should embrace the use of assets that produce predictable cash flows at higher yields than gilts. A range of strategies could be employed, including long duration buy-and-maintain credit as well as a wide range of alternative income assets that provide a higher return than traditional fixed-income, whilst also increasing diversification. Pension schemes, by virtue of the fact they are not subject to onerous insurance regulations, can take advantage of an even wider asset universe than their insurance counterparts.
2. Move away from investing relative to market benchmark and focus on the outcome that matters – The use of benchmark indices and the calculation of added value relative to such benchmarks are entirely artificial given the key objective for pension scheme of generating sufficient income to pay liability cashflows. Indeed, in the case of market-weighted bond indices, investors are effectively placing their biggest bets on the most indebted companies. We believe that by embracing this approach, a pension scheme can more efficiently meet its needs for returns, risk management and delivering reliable cashflows to meet its liabilities.
