As LDI strategies are gradually being replaced by CDI approaches, how are pension schemes managing the additional risks that come with chasing higher-yielding assets?
Looking at short and medium-term challenges for defined benefit (DB) schemes can be scary. A growing number are closed to new members and with the ratio of deferred-to-active members rising, so too have the liabilities.
It’s no wonder then, that DB schemes, with an eye on matching cash-flow to their growing mountain of liabilities, have gradually reduced their equity allocation in favour of higher-yielding bonds. Dumping equities for bonds is often seen as a risk-reducing strategy. But distorted valuations in fixed income markets in a post-quantitative easing world mean that switching to tradable debt does not necessarily mean scheme managers can sleep any easier at night.
Instead, artificially low interest rates resulting from monetary policies are forcing investors to access a broader spectrum of asset classes and to move up the risk curve in order to unlock those desired cash-flows. This raises some questions: should cashflow driven investment (CDI) be described as a risk reducing strategy? Are investors not just accessing different types of risk; credit and liquidity, in particular? Is a higher allocation to cash-generating fixed income assets always the best option for schemes on the road to self-sufficiency? And what alternative options do they have?
In order to understand the key drivers behind the growing interest in cash-flow driven investment strategies, it is worth taking a step back to some broader changes in the UK pensions’ landscape. While the majority of UK pension scheme assets are still held in DB schemes, only 12% of private sector final salary schemes are currently open to new members and roughly half are only open to future accrual.
Consequently, 56% of DB schemes in the UK are currently cash-flow negative and almost half of all cash-flow positive schemes are less than five years away from joining them, according to Mercer’s latest asset allocation survey. Another factor driving the trend for CDI is the sharp increase in transfer rates as a result of the introduction of pension freedoms, which is making changes to liabilities harder to predict.
In response to these challenges, UK DB schemes have further reduced their equity exposure, from 29% to 25% year-on-year and are instead looking to expand their share of liability-hedged ratios and alternatives in a bid to match growing liability pressures. This cash-flow oriented approach might not necessarily contradict liability-driven investment (LDI).
Both approaches can be complementary, Annabel Gillard, director of global institutional distribution at M&G Investments, believes. “Most schemes which have an LDI strategy in place apply it though a derivatives program involving synthetic assets,” she says. “The problem with that is the increasing regulatory complexity of it. “So a lot of pension funds have started applying a strategy which looks a bit more like an annuity fund.
“This investment style is more about building a portfolio of real assets whilst aiming to achieve predictability of cash flows over time, for example through a mix of real estate assets, private debt, infrastructure, conventional- and index linked gilts. “The problem with a scheme restricting itself to gilts is that it’s quite an expensive way of matching liabilities, so leaves the scheme very dependent on their growth portfolio for return, which could otherwise be achieved by including other sorts of credit as part of the matching portfolio,” Gillard adds.
RISK VERSUS RETURN
A recent report by Aon groups cash-flow driven investments into five broad areas, ranging from accurately matching risk levels at lower returns (gilts and cash in particular) and assets offering higher income for a greater exposure to credit or liquidity risk.
The higher income assets range from corporate bonds, accessed in the form of buyand-hold strategies, credit default swaps, asset-backed or insurance-linked securities and emerging market debt. Then there are less liquid assets such as real estate and infrastructure debt or direct lending, which can beat the returns offered by gilts several times over.
Yet the persistent low-yield environment has put some serious constraints on fixed income investments. Take the UK corporate bond market, for example, where a recent Financial Conduct Authority (FCA) report revealed that liquidity has declined significantly from mid-2014 onward.
Moreover, the limited volume of issuance in UK corporate bonds will inevitably turn investors towards global and higher-yielding emerging market corporate bonds, where higher default rates could also be a factor of concern.
Consequently, pension fund trustees should weigh-up carefully whether a precise matching of cash-flow is the right option for them. It all depends on where they are on the road towards full funding, argues Ritesh Bamania, head of UK institutional clients at Lombard Odier.
“There is a lot of talk about bonds and illiquid assets to match liability outgoings, but no one really talks about the growth side of the portfolio in the context of CDI. The question is what would happen to the portfolio, especially one with a lot of illiquid assets and leverage, during the next crash?
“Many clients using CDI might match liabilities in 15 or 20 years, but what happens to pension payments over the next seven years?” he warns. “Leverage can be a good thing, but it is not free and can be costly, especially if rates go up.”
Schemes should respond to this challenge, according to Gillard, by focussing on a precise match of liabilities over the shorter term.
“I would agree that there is some risk to cash-flow driven investing, but as a DB scheme faced with negative cash-flows and immediate liabilities, you don’t really have a choice but to manage your cash-flows more precisely,” she adds.
“This won’t involve the leverage that LDI approaches rely on, but will increase liquidity and credit risk. The answer to that is that you will need a good manager who has the capability to manage schemes’ short-term cash-flow requirements.”
AWARE, BUT NOT MATCHING
One scheme which has applied a cash-flow orientated strategy to match its liabilities is HSBC’s £27.8bn final salary scheme. In some ways it is a classic example of where a cash-flow driven approach might be beneficial.
The scheme closed for further accrual in 2015 and with no new contributions coming in and more than 100,000 retired members and deferred members remaining, the trustee’s key priority is to ensure the security of cash-flows, whereas the growth side of the portfolio is of relatively lesser importance.
In order to match these cash requirements, the scheme invests more than half of its assets in a combination of an LDI strategy offered by Insight Investment and indexlinked sterling credit as well as UK property and infrastructure debt.
Other schemes, which find themselves at different stages of maturity, prefer to describe themselves as cash-flow aware, rather than prioritising a closer match of liabilities.
One example is the London Borough of Ealing’s retirement scheme. Almost a third of the scheme’s members are still active, making precise cash-flow matching a less sensible option, says Bridget Uku, the scheme’s group manager of treasury and investment.
Speaking at a roundtable hosted by portfolio institutional earlier this year, Uku said the scheme’s strategy can best be described as cash-flow aware, rather than cash-flow driven.
“We are paying pensioners mostly from contributions, but further down the road we are going to use our dividends, coupons and whatever else to pay the cash-flow.
“So we are de-risking at the moment,” she adds. “What we have done is take 10% out of equities to put it into higher-yielding assets, so we have put 5% into private debt.
There you are churning out contractual cash-flows, looking for quality, secure, sustainable
income to manage those cashflows going forwards.”
Another investor reluctant to describe his scheme’s approach as cash-flow matching is James Duberly, director of pension investments at the BBC Pension Scheme.
This comes despite the broadcasting giant’s scheme’s investment returns as of 2017 broadly being in-line with its liabilities and equity exposure had been reduced significantly. “We don’t use the term cash-flow driven investing as it could be taken as meaning something akin to portfolio immunisation, which would not be a good description of our process,” Duberly says.
“However, over the years we have acquired what we describe as ‘alternative matching assets’, such as infrastructure and longlease property, that offer the prospects of stable long-term cash-flows that are aligned to the scheme’s liabilities.
“We think these assets improve the scheme’s risk adjusted returns as part of a diversified portfolio that includes traditional liability driven investments (i.e. gilts and swaps), as well as other listed assets,such as corporate bonds and equities,” he adds.
Using alternatives, such as property, could add a welcome bit of simplicity to pension scheme’s portfolios and is therefore increasingly popular, says Gillard.
“Having lived through LDI, I would say that it is actually more complicated than CDI,”she adds. “With the latter, you are actually talking about owning a portfolio of tangible assets such as property rather than derivatives to hedge interest rate risks, so in that sense CDI is a lot easier to grasp than LDI.
“What we have seen with a lot of schemes is alternatives matching, which means using long-term real assets as a quasi-hedge On its own, it could be a step on a journey towards CDI” she predicts.