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Cash-flow driven investing

Cash-flow driven investing roundtable: The discussion

Friday 2nd March 2018

More than half of DB pension schemes are either cash-flow negative or are close to it, according to Mercer. Is this what you are seeing?

Giles Payne: I’ve got one which is testing us at the moment. It is £12m a year negative, but as the contributions stop and the recovery plan finishes it will move to £40m to £50m negative in a couple of years’ time. So generating cash to pay benefits is becoming more relevant. Then you’ve got the other issue that more and more people are looking to take transfer values, certainly higher transfer values. So that immediately creates a cash generation issue as well.

Adam Lane: That definitely resonates with Mercer’s clients. Often when they first experience cash-flow negativity it’s a good thing. That means contributions have switched off for the first time and then it’s all about finding income to pay benefits. That’s just testament to the good work the trustees have done to reach a fully-funded position in recent times, but the transfer value issue is a big one. That’s what is causing a real challenge for trustees, particularly if it is ad-hoc and you don’t know when it’s coming and the numbers can be quite large.

Where does cash-flow matching sit on your scheme’s agenda, Bridget?

Bridget Uku: We’re still generating a lot of contributions and getting new entrants. Although we’re getting transfers-out, we’re also getting transfers-in, so it’s not high up on our agenda. It’s difficult to profile our cash-flows and the governance that would be required to run a cash-flow matching strategy, it is not something we would want to do, at the moment anyway.

But you might have to one day.

Uku: We are definitely cash-flow aware. We certainly use our cash-flows to determine asset liability studies. We’re doing a lot of re-balancing at the moment, so there’s a lot of cash moving around. Plus, we have one-off lump sum payments from the employer every so often, so it means that we are managing our cash-flows, but we’re aware of it.

Andrew Harrison: If you’re not well funded and your liabilities are still reasonably uncertain then matching cash-flows is not necessarily such a good idea. So it depends on the circumstances of each particular pension fund.

Graham Moles: The clients implementing fully cash-flow matching strategies are definitely towards the better funded stage. However, clients are starting to think about putting strategies in place to move towards cash-flow matching or looking for other ways to generate cash-flows. For us it’s not a silver bullet in terms of matching every single cash-flow perfectly because they’re not certain.

Payne: Everyone is saying that markets are fully valued and what you don’t want is to sell assets after the markets have fallen. So by actually generating cash, even if it is for the next expected three, four, five years’ liabilities, you are protecting yourself from having to sell assets at an inopportune time.

John Dewey: I tend not to use the word “matching”. It implies a precision and a certainty that is sometimes unhelpful. Almost every pension scheme is somewhere on this journey towards maturity and cash-flow negativity. Nothing changes overnight on the day you become cash-flow negative, but what is clear is that you have those issues about a greater certainty of outcomes if you invest in an asset that can deliver cash-flows rather than an equity-like exposure. Also, this traditional view of growth versus matching overlooks a host of exciting assets that have dual characteristics. They maybe aren’t the best at growth or at matching, but in aggregate can provide excellent outcomes for pension schemes.

Lane: Most DB schemes today don’t have a cash-flow problem. They may have challenges around liquidity in the short-term, but the challenge they face is certainty of return. That’s where some of these assets really come into their own. An equity portfolio gives you little certainty about the next 20 years, while a portfolio cleverly designed as an income-generating portfolio gives you the observable yield and the observable cash-flows. That’s what delivers certainty.

David Weeks: Our member-nominated trustees will recognise this picture of maturity plus cash-flow negativity. Quite a lot of them were closed some time ago and have parent company sponsors who would like to get the whole thing off the balance sheet and close it down.

Moles: When you are investing in longer term assets you are harnessing the benefits that a pension scheme has in being a long-term investor. There is a mind-set shift you’ve got to take in looking at longer term risk metrics. Credit over one-year versus equities might not be as rewarding, but over 15-years it has a very different risk and return profile.

Lane: From a portfolio perspective, a traditional growth investor looks to maximise risk-adjusted returns, and that’s great, but pension schemes should be looking at risk-adjusted returns times maturity. What we’re talking about today is how to maximise that. Where you sit on the maturity spectrum is important. As schemes become more mature, liquidity becomes more important and the certainty of the cash-flow becomes more certain.

Jeremy Richards: Historically the scheme has been looked at as a whole thing, but taking it from a hardcore matching point of view you’ve got two different sets of liabilities with two rather different objectives. Your pensions and payments are a different beast to your deferreds, where you require liquidity but they may or may not crystallise into actual cash-flow liabilities. You could almost think of it like different investment strategies and different segments of the fund, because trying to cash-flow match deferreds is problematic and expensive.

Payne: Unless you are incredibly well-funded.

Uku: It is about maybe looking at a sub-set. Some LGPS schemes are looking at cash-flow matching for their pensioners. That is easier to define.

Cliff Speed: You’re right about certainty of outcomes. Maturity is thinking about how much of your assets are going out the door annually. If it’s 3% you’re quite severely cash-flow negative, but you could probably deal with that with income. As soon as that starts rising you’re in a situation where you’re definitely realising assets and if you are realising an asset after a significant fall there’s a leverage in the future return you will need if you have to do that. The more mature assets going out the door, the better you want to align those cash-flows with expected liabilities.The difficulty is with deferreds because there is so much greater uncertainty in the cash-flow. So you are trying to balance being well-aligned with benefits going out and asset income, with sufficient liquidity to deal with those uncertain cash-flows. That’s the evolution we see as schemes mature. Starting with a lot of actives is not really practical, but as you start to build that up, starting to make sure you’ve got cash-flow alignment for the pensioners makes a great deal of sense.

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