Ian Peart
A recent independent survey commissioned by Buck Global Investment Advisors (BGIA) has provided extensive data on the current cash flow requirements of respondents’ pension schemes, and how these requirements are managed.
Steep rises in the costs in recent years of providing a defined benefit (DB) pension scheme have meant that many employers are finding it unviable to continue to offer traditional final salary arrangements. As more and more schemes close, this removes a source of future positive cash flow in the form of employer and employee contributions, which these schemes previously relied upon to meet their cash flow requirements. We remain concerned that few UK DB pension schemes have adequate arrangements in place to manage their cash flow needs efficiently, and believe this is a major issue that needs to be urgently addressed.
Of those survey respondents whose schemes were expected to be cash flow negative in 2013, almost one-third do not currently draw down investment income to meet the net cash flow requirement. A portion of these respondents are holding funds in cash to meet net outgo, thus forfeiting investment returns on this portion of their scheme’s portfolio.
Indeed the survey indicated that over half of respondents (53%) are holding substantial scheme assets (greater than 2%) in cash to meet benefit payments. Others will be making regular disinvestments from their asset portfolio, incurring transaction costs each time. Crucially, the survey revealed that 25% of respondents were not aware of the costs they are incurring by selling down their scheme’s investments to meet benefit requirements. While these costs will vary significantly by asset class, they can be up to 2% of total assets sold when transacting out of a UK Property Fund, for example. It is important that trustees are cognisant of such costs, and look to minimise them.
Clearly many schemes are not considering, on a relative basis, the opportunities for meeting cash flow in a more efficient and less costly manner. Yet there are a number of approaches that can be successfully implemented, affording trustees considerable cost savings relative to standard scheme practice.
For example, a number of our clients’ fixed income portfolios have been put to work to provide a regular source of income that is expected to meet all, or a defined proportion of, the benefit outgo. There are two main approaches to achieving this aim: a pooled fund structure, or a segregated portfolio. A great many investment managers have launched ranges of pooled funds that are designed to be used to match the cash flow requirements of individual pension schemes.
Whilst these funds have been associated with ‘liability-driven investment’ and higher levels of interest rate and inflation hedging, they can be used flexibly, with a focus on delivering income to meet benefit payments. Pooled fund approaches are relatively simple to administer, being based on frequently-quoted unit prices, with custodian services provided within the funds. For schemes with fixed income holdings valued at £50m or more, there is the option of holding a segregated, bespoke fixed income portfolio designed to meet net cash flow requirements. The investment manager would purchase individual bonds and gilts to construct a portfolio in which coupons and redemption proceeds are expected to be sufficient to meet the scheme’s net cash flow. This approach can be adjusted to include an element of active management, combinations of corporate and government bonds, and interest rate or inflation hedging according to scheme specific objectives.
In other instances, schemes draw down income from other asset holdings on a monthly or quarterly basis with equities and property, for example, providing a valuable, and often overlooked, source of cash flow. The amount available will obviously depend on the scheme’s asset mix and the income yields on the underlying holdings at any given point in time. Clearly, as income is being distributed, the transaction costs that would have been incurred on reinvestment and subsequent sale are avoided.
A wealth of tailored opportunities and benefits to manage cash flow efficiently are available and being successfully used by the minority. Too few are capitalising on these with the result that inefficient cash flow management sadly remains prevalent within the UK pension fund industry.
Ian Peart is senior investment consultant at Buck Global Investment Advisors
Comments