As defined benefit (DB) pension schemes mature and become cash-flow negative, cash-flow management becomes increasingly important. Schemes may be better off focusing on being cash-flow aware than being cash-flow matched.
Executive summary
– Schemes, particularly under-funded ones, may be better off focusing on being cash-flow aware than being cash-flow matched
– Being cash-flow aware means seeking to use not only the cash-flows from bonds, but also the natural cash-flows from other types of investment such as real assets and equities
– Cash-flow awareness does not replace cash-flow matching. In the short-to-medium term it usually makes sense to at least broadly match benefit payments
– Trustees should also prepare for unexpected cash-flows such as transfers out. This involves taking pre-emptive steps to boost liquidity
What is causing the cash-flow issue?
Defined benefit (DB) pension schemes are maturing. According to Mercer’s 2017 European Asset Allocation survey, more than half of UK DB pension schemes are cash-flow negative or soon will be, with 85% of cash-flow positive schemes expected to turn cash-flow negative within 10 years. Cash-flow negative schemes are paying more out in benefits than they are receiving in contributions.
At the same time, there are other pressures that mean precisely matching all benefits is not necessarily possible or ideal. These include: Underfunding (assets lower than liabilities), longevity risk (the risk that scheme members live longer than expected) and sponsor/covenant risk (the risk that the sponsor becomes insolvent).
What can schemes do to manage their cash-flows better?
The most important aspect of managing cash-flows is getting the broad asset allocation right – trustees should not lose sight of the big picture. We recommend examining the long-term distribution of outcomes the scheme might face using a model that takes into account the scheme’s circumstances, including how cash-flow negative the scheme is. Success is either paying all pensions as they fall due or paying as high a percentage of those pensions as possible.
Trustees can choose the investment strategy with the most attractive profile of future outcomes and decide how much to allocate across broad asset classes. However, this is not the whole story – assets should also be structured in a cash-flow aware way subject to this broad split.
We suggest the following additional steps:
1) Prepare for expected cash-flows
a) Target cash-flows in the short-to-medium term
We recommend structuring assets so that a high proportion of cash-flows are met by natural cash-flow generation from assets for approximately the first 10 years.
b) Turn on the taps – use all natural cash-flows
Bonds and some real assets generate contractual cash-flows. These can help reduce scheme risk even if the cash-flow match is imperfect. Although they are not contractual, dividends from equities can also be aligned with pension payments.
c) Use an appropriate growth strategy to meet long-term cash-flows
There is a variety of different approaches available to trustees targeting a more cash-flow aware growth strategy. These include income-generating multi-asset funds and equity strategies that focus on selecting companies with sustainable dividends that grow with inflation.
2) Prepare for unexpected cash-flows
a) Pre-emptively increase liquidity
There are various potential ways of increasing liquidity in a pension scheme without compromising its risk-return profile:
– Increase flexibility and efficiency of leverage: LDI offers leveraged exposure to rates/inflation and therefore frees up cash
– Consider tailoring growth asset exposure: adopt a cash-flow aware strategy and avoid excessive allocations to illiquid assets
– Consider using uncorrelated funds or market neutral funds with a low expected maximum drawdown as a safety net
b) If asset sales are needed, allow for costs and any active views
Most schemes currently use up cash and then increase leverage in their LDI portfolio to meet unexpected cash-flows. If this is not sufficient or leverage levels are already high, they may also make use of cash-flows available from growth strategies.
Once these avenues are exhausted, it is likely that the scheme may need to sell assets, possibly in stressed conditions. Schemes should sell assets that move the scheme towards the most attractive asset allocation today (allowing for any carefully researched active views) but bearing in mind transaction costs.
3) Be proportionate
A simple plan or priority order may sometimes be appropriate, especially if schemes have a limited governance budget. For example, some trustees might consider selling relatively liquid growth assets first, followed by LDI and leaving the sale of illiquid assets as a last resort. Others might prefer to reduce their hedge ratio before selling growth assets.
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