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CDI: Waving or drowning?

26 Mar 2019

With just 14% of UK defined benefit (DB) pension schemes open to new members and future accrual, cash-flow has become a focus for the other 86%.

Some 1.2 million pensioners are in schemes that receive no new money, The Pensions Regulator said in November, with just 11% of UK scheme members actively contributing.

An astounding 41% of all DB pension scheme members are drawing benefit, according to the regulator, with 48% of members deferred, meaning that they could request regular payments at any time.

This means pension schemes need to generate a regular cash income to pay these members rather than just recycling new contributions.

A couple of years ago, after looking at this increasingly mature UK pensions landscape, some fund managers and consultants turned to the insurance market for inspiration. Annuity providers and other insurance companies need regular cashflows to make agreed, regular payments, but do not receive regular contributions. Instead they use a cash-flow driven investing (CDI) approach to ensure they can meet their payments and hold a range of low-risk fixed income securities that fall in line with their regulatory requirements.

With pension funds needing a similar cashflow profile, it might have been thought that they would happily follow that route too, but it has not turned out that way – at least not yet.

READY FOR ACTION?

The fly in the ointment is that most UK pension funds are not in a position to lie back and begin their final act.

Just 3% of schemes were in wind up in November, according to TPR, accounting for just 52,547 members.

For the rest of the schemes closed to future accrual, despite being fairly sure of whom they need to pay and for how long, there is an additional, somewhat bigger fly.

At the end of December, some 3,271 UK schemes were in deficit on a buy-out basis, according to the Pension Protection Fund (PPF). This meant just 40% of the schemes eligible for entry into the lifeboat had enough assets to push them through to the end.

For the 60% that find themselves under water, they are at least one step away from setting up a cash-flow matching investment strategy, which relies heavily on fixed income rather than growth assets to close any gap. But even for the 40% that could potentially consider the approach, few have been willing.

Even the PPF, which was 123% funded in March 2018, does not run a CDI strategy, according to chief investment officer Barry Kenneth. Instead, an in-house liability-driven investment (LDI) strategy manages the economic risk of future cash-flows.

“CDI is a cash-flow matching strategy and thus your assets would have to be fully invested in fixed income,” Kenneth says. “In order to implement this across the whole fund efficiently, the return hurdle of the pension scheme would have to be the same or higher than the yield on the portfolio of bonds/cash-flow instruments to have enough money to pay the cash-flows.”

From a portfolio construction perspective, there may need to be some compromises made when juggling diversification of sector exposure and matching cash-flows. For example, long term inflation-linked cashflow issuers can be very sector-concentrated. Utility companies and banks are big issuers of these securities, whereas other sectors prefer rates set by the market.

In the UK there is around £400m in investment-grade bonds. There are close to £2trn in pension liabilities.

Alex White, Redington

Unlike LDI funds, which match investments up to specific liabilities to be converted or sold to create a cash-flow at a certain date and can be created using a range of derivatives, including swaps, CDI strategies are usually not created using leverage. This means the whole portfolio must be dedicated to one end goal, using up its entire firepower.

While investment grade and governmentissued bonds are often preferred, real estate and infrastructure can give a steady enough return to meet cash-flows.

However, unlike an LDI strategy, which traditionally has a growth and matching portfolio running alongside, should a significant part of this CDI portfolio default, there are no growth assets left to take the strain and sweat a little harder to make up the gap.

There have been suggestions that just a slice of a pension that was linked to a section of scheme members – retired or deferred – could be managed on a CDI basis. But this increases the governance needed to oversee a strategy that sounds a lot like a partial buy-in or annuity that an insurer could do (albeit at a cost).

THE NAME’S BOND

A reliance on bonds causes other barriers for CDI enthusiasts.

Alex White, head of ALM research at Redington, says that there are difficulties in the details of cash-flow matching. “For example, if you want to buy a large, diversified, liquid investment-grade credit portfolio you may struggle to do so purely in sterling,” he adds.

“For context, in the UK there is around £400m in investment-grade bonds. There are close to £2trn in pension liabilities.” Instead, pension fund investors may need to look further afield, to the biggest corporate bond market in the world: the US, where the markets are worth around £5tn.

However, despite the deep liquidity in these markets, there are two problems for UK investors.

First, most corporate bonds have a maturity of up to 10 years. After that, the money is returned, and the lender has to seek out another company that wants to borrow. This introduces reinvestment risk as there is no guarantee that the market will not have moved and what a pension fund needed may be trickier (or easier) to find. Even if corporate bonds were available at tenors as long-dated as pension liabilities, strong companies are quite likely to become weak companies over long (30 to 50 year) horizons, so schemes would not be able to rely on holding these investments to maturity.

Becoming a long-term creditor for a company is a different matter to lending over decades to a state or nation.

Additional issues with investing in the world’s largest bond market come with its currency. While investors riding the crest of a strong dollar for the excess carry trade may appreciate the divergent economic policy, for those looking to match the regular returns against cash-flows, the picture is not as appealing.

“Once you are holding dollars, you have a currency mismatch,” White says. “You have to hedge it, and you cannot know what cash requirements will be needed to pay for the hedge if the dollar goes up.”

These hedging requirements need constant oversight and collateral calls could be frequent. They can also be greater than the cash-flow you were expecting from the bond. While this does not render them bad investments, it does make it harder to use bonds directly to match cash-flows.

So how has the insurance sector made CDI work?

SUCCESS STORIES

Pension Insurance Corporation (PIC), which takes on the assets and liabilities of DB schemes to manage to maturity, has an entire fund following CDI principles.

It already has a head start on most DB funds as the schemes it takes on are at least 100% funded.

“If you are a pension provider, why take the risk of not being able to pay them?” asked Mark Gull, PIC’s head of fixed income.

The specialist insurer’s CDI portfolio is concentrated on high-quality bond issuers, such as utility companies and banks, that have a low probability of default and issue debt linked to inflation.

The investment team also hedges the inflation risk though inflation-linked gilts – of which there were just £28.5bn issued by the UK’s Debt Management Office in the 12 months to the end of March 2018 – or through swaps with a counterparty.

Unlike pension funds, which are encouraged to invest for the long-term, insurers such as PIC are bound by different rules. Another reason for the popularity of CDI is that it fits with the mentality of insurance investors.

“Solvency II encourages you to match in annual buckets,” Gull says, meaning PIC can pick through primary and secondary markets to find appropriate bonds to buy. Equally, as one of the largest insurers in the sector, which has a dedicated origination team, PIC can craft the instruments it needs.

“Not many pension funds have the skills and specialisms needed to run a CDI strategy,” Gull says.

“But they also do not have the same pressures on regulatory capital and are able to hold equities for a long time, which PIC cannot.”

YOU CAN GO YOUR OWN WAY

Equities and other growth assets are invaluable when pension funds are hit with an unexpected spike in longevity, for example, as they have the freedom to flex and shift investments.

But freedom can spell trouble in other ways for DB schemes considering a CDI strategy.

“While your cash-flow needs might be between 2.5% and 5% of your overall portfolio, the collateral calls on an LDI portfolio could be 20%,” says White at Redington. “Even without any hedging, we have seen in many schemes that transfers of around 4% can be taken out in a year by members leaving the scheme, which again makes your cash-flows less well-known.”

While members have been able to pull small amounts of pension pots for some time, the pension freedoms announced by former Chancellor George Osborne, have led to millions of pounds being withdrawn from schemes.

It is difficult for any CDI model to factor that in accurately, and is a major reason why, for White at least, “cash-flow matching is an intuitive idea, and cash-flow management crucial; but for many schemes the operational detail can make it a lot harder to get an accurate cash-flow match from bonds”.

However, as pension funds continue to mature, Jordan Griffiths, investment consultant at Quantum Advisory, says more of his clients are considering a CDI approach instead of going down the route to buy-out or take a bulk annuity.

If you are a pension provider, why take the risk of not being able to pay them?”

Mark Gull, Pension Insurance Corporation

“It is very client-specific,” Griffiths says, “and depends on the covenant and whether the pension is fully-funded.”

The certainty of returns and hedging out of liabilities is attractive to some pensions, according to Griffiths, who says some were considering taking short-term CDI strategies as part of their overall risk management.

“Pension funds are used to using LDI,” Griffiths says. “Many had large deficits, so matched inflation and interest rate risk while using growth assets to make up the difference.”

And LDI has a place alongside a CDI approach, he adds, but accepted that it would involve some complex engineering. Therefore, Quantum is creating a CDI structure in the mould of the pooled LDI strategies launched at the start of this decade.

“It aims to simplify the process and make it available to the wider market, including smaller schemes,” Griffiths says.

But as markets around the world look unsettled and pensions edging closer to solvency see the insurance sector already wellversed in CDI happy to take on their liabilities, it might take a trustee board with a strong constitution to go it alone – at least in the short term.

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