John Dewey, head of investment strategy, global investment solutions, Aviva Investors
While liability-driven investment (LDI) and growth approaches will remain a key part of the toolkit for defined benefit (DB) pension schemes, there is a strong case to be made for incorporating cash flow-driven investing (CDI) into their strategies.
CDI can deliver the predictable returns of LDI strategies but at higher yields, while diversifying portfolios and drawing on a wide range of return premia.
Traditionally, market returns from growth assets – such as equities, property or diversified multi-asset portfolios – have been used to do the heavy lifting of generating long-term returns. But experience has shown that simplistic diversification across listed markets can fail to deliver protection when it is needed most: when volatility is high, asset prices are falling and correlations rise.
At the same time, there is more emphasis on path dependency: the possibility that several years of poor returns might deplete assets, so that meeting long-term funding targets becomes unviable.
Kicking the usual bucket approach
Rather than following a conventional approach, which broadly splits assets into growth or matching categories (hedging liabilities in line with movements in interest rates and inflation), pension schemes should consider assets that provide reliable income at a premium above bonds and swaps. These may not fit naturally into either of the traditional buckets.
Investment strategies focused on such assets, generally termed CDI, do not all provide a perfect match for liabilities, but can offer an attractive middle ground, depending on individual requirements.
Income-producing diversified growth: A multi-asset portfolio of listed assets tailored to pay out regular income is one way to meet the cash-flow demands faced by maturing pension schemes.
Annuity style credit: Credit portfolios can be constructed to meet specific cash-flow needs and held to maturity. With customised buy-and-maintain approaches, interest rate, inflation and cash-flow exposure can be tailored to the liability profile.
Private assets: Private assets (infrastructure debt, real estate debt, private corporate credit and other structured finance transactions) with transparent cash-flow characteristics can provide higher yields through illiquidity premia and diversified return premia.
Optimal assets have bond-like characteristics, but offer better yields with less risk. Unlevered infrastructure is particularly attractive, since it can offer regulated returns that deliver annual income of over 7%, without leverage.
Finding solutions that fit
Determining the balance between growth, LDI and CDI needs a detailed understanding of a scheme’s objectives and cash-flow requirements. If a scheme has a medium-to-long-term time horizon, and a tolerance for less liquid assets, private assets merit exploration. Conversely, if a scheme is well funded and targeting a buy-in or buy-out in the short to medium term, it will typically need a robust mark-to market hedge and the balance should remain towards LDI.
Next steps
As cash-flow negativity is becoming more prevalent, pension schemes need to put cash-flow at the heart of their asset and liability management strategies. Once a scheme truly understands how its commitments will change, it can test multiple scenarios to understand how portfolios will perform in different market environments.
An evolution to CDI represents a natural step for a large number of maturing schemes, and should contribute to more effective investment strategies in the years ahead.
Important information
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 13 February 2018. Unless stated otherwise any views and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors). They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Issued by Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office St Helens, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St Helens, 1 Undershaft, London, EC3P 3DQ.
