Rather than selling down its equity portfolio, it could instead decide to sell a portion of its bond fund to protect its growth assets. Hodgson says: “But most schemes are reluctant to sell these as they are holding them to match future liabilities. So understanding liquidity is imperative.”
Troup adds: “The most pernicious combination is an unexpected, immediate cash-flow requirement, a large deficit, a lack of liquid assets and a falling financial market.”
In those circumstances, the schemes are locking in a reduction in their asset base and so increasing the other risks facing the scheme, she adds.
In other words, the scheme cannot consider these demands in isolation – they need to be balanced against the other risks the fund needs to manage.
“Trustees need to look at the scheme holistically,” Troup says. Nor is it helpful to dwell on the past. “If changes need to be made, the trustee must think of it as the first day of the rest of the scheme’s life,” adds Troup. That helps a trustee to always make explicit risk decisions rather than being forced into taking implicit risk decisions.
PLANNING AHEAD
The amount of risk a scheme can afford to take will depend on the strength of sponsor covenant.
If a scheme decides, for example, not to sell some of its growth assets to fund the liquidity requirements when markets are falling, the trustees need to be sure that’s the decision they want to take.
Troup says: “Deciding to hold on to the growth assets when they are losing value should be an explicit decision which is dependent on the strength of the covenant.”
To avoid being bounced into taking implicit risk decisions, it helps for the scheme to have a plan. The first step in that plan is mapping out future cash-flows – both income from assets and liabilities and likely expenses.
Aon partner Lucy Barron says trustees need to consider how much cash is being generated from existing assets and if that will either match or fall short of the scheme’s likely cash-flow requirements.
It is not just about mapping out the likely liability payments to pay the members’ benefits – it’s about considering the circumstances when the scheme might need more liquidity. “If interest-rates rise then a scheme with LDI might also need extra cash to top the required collateral pool,” Barron says.
Once these cash-flows have been determined, trustees can see how they can use the scheme as it is today to increase liquidity. Troup says: “It might be possible to increase the amount of leverage used in the liability-driven investment strategy.”
For example, a scheme could use more interest-rate swaps or gilt repos to free up cash. Another option could be schemes using synthetic equity or credit, in the form of equity options or credit default swaps.
“But for some schemes these synthetic opportunities may be limited as they will already have maximised their leverage,” says Troup.
If increasing leverage is not an option, then tailoring the growth assets might be. “For example, a scheme might decide to focus on dividend equity strategies or multi-asset funds, which generate income,” Troup says.
Alternatively the scheme could have market-neutral absolute return funds. These should only see their valuations fall by a relatively small amount if there is a market correction.
“These could be liquidated quickly if cash was needed,” Troup says. But these decisions need to be made in the context of the risk management framework. “The modelling needs to include the covenant risk to enable a scheme to determine how much risk it can afford to take,” Troup says.
This is an important consideration because the average scheme sponsor has a BB+ credit rating. Troup says: “Over a 20-year period, around a third of those companies would default when the average scheme would still have more than half of their liabilities left to pay.”
In other words, covenant risk is a real issue which must be included in the overall asset allocation decisions. “There is a danger that if schemes do not include this risk in their decisions, they could create real problems in the future,” Troup says.
But even if schemes do plan out their cash-flows and try to avoid being bounced into implicit decisions, there is a danger that pursuing a purely cash-flow matching strategy will cause them to neglect their other goals.
P-Solve co-head Ajeet Manjrekar says: “That’s not to say this isn’t a risk but it is not necessarily the key priority of a scheme today, given the state of DB funding levels.”
Blackrock director of client solutions Vivek Paul agrees. “There can be too much focus on cash-flow,” Paul says. “While it is important, the risk and return elements of the rest of the portfolio are crucial.”
