RELEVANT FACTORS
Cash-flow is only one of a number of important considerations. Aon’s Lucy Barron says: “A scheme’s return requirement; the level of risk it can take in its investment strategy; the strength of the covenant and the maturity of the scheme are all relevant factors.”
There is a danger schemes will focus too closely on cash-flow negativity rather than the overall target of closing their funding gap.
Manjrekar says: “Most schemes are using LDI and some leverage in combination with return-seeking assets to generate the returns needed to close the gap.”
If a scheme takes part of those assets to match cash-flows, there are fewer assets left over to reduce the funding gap.
Manjrekar says: “If a scheme decides to allocate 20% of its assets into a cash-flow matching solution then there are only 80% of the assets left to close the funding gap and match the interest-rate risk.”
A focus on cash-flow matching assets could result in a scheme making a trade-off between reducing the return the assets will make, thus lengthening the time to close the funding gap; or, the scheme decides not to maintain the same level of LDI and introduces greater funding level volatility.
Schemes should be prioritising their future. “Schemes need to think about what their priorities are given where the scheme is today relative to its long-term funding goal,” Manjrekar says.
The problem is that schemes do not think about those long-term goals in the right way. “Too often they frame their position relative to technical provisions rather than a longer-term funding measure,” Manjrekar says.
If a scheme has targeted a buy-out as its ultimate goal it should actively work towards that target in tandem with the covenant sponsor to achieve it, he adds. “That enables the scheme to understand the risks it faces and the level of return it needs to generate.”
Then the scheme should take a closer look at its assets to determine what liquidity it has. Manjrekar says: “Most schemes already have enough liquidity in their investments along with a tolerance to take some illiquidity to generate extra returns.”
It is also important to consider current market conditions. Manjrekar says: “For example, corporate bonds would address some of your cash-flow requirements but credit spreads are at all-time lows, so we question whether investors are getting paid enough for the risk.”
Those types of returns will not enable a scheme to effectively close its funding gap and meet its longer term cash-flows, he adds.
Paul agrees: “If a scheme focuses just on an asset’s ability to generate cash-flow, it could end up investing in assets which do not meet its other goals.”
The only schemes which should be considering a full cash-flow matching strategy are well-funded, mature schemes.
Barron says: “Cash-flow matching strategies are most suitable for schemes which only need to generate returns of gilts plus one or two percentage points and where they are targeting self-sufficiency.”
But even those schemes will not want to buy overvalued, under-returning assets just so they can match cash-flow. “If corporate bonds do not look good value, then schemes could also consider investing in cash-generating alternative assets,” Barron says.
