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Janus Henderson: Cash is king for DB pensions

16 Mar 2020

Norbert Fullerton

Head of institutional client strategy, EMEA Janus Henderson Investors

Strategies focused on generating income need to be a key feature for DB pension funds in 2020 and beyond.

The changing landscape

In 1998, one of my first tasks when I entered the actuarial profession was to work out the level of defined benefit (DB) pension fund surplus that could be refunded to the sponsoring employer or shared with members via uplifts to their pensions. Those were the good old days when most pension funds were open to new members.

Today, the DB pensions landscape has changed dramatically. Most DB pension funds are closed, have increased in maturity, have huge deficits and are focused on managing various risks associated with their sponsor, assets and liabilities. Funding levels have also improved since the nadir of the global financial crisis, thanks to the last decade of deficit payments from sponsoring employers and a bull run in equity markets. Trustees and sponsors have, therefore, shifted their focus towards conservative endgame strategies. Whether the endgame strategy is to achieve self-sufficiency (i.e. there is low dependency on the sponsor) or to transfer liabilities to a commercial DB consolidator, or buyout with an annuity provider, the challenges are the same. While funding levels have improved, the vast majority of DB pension funds still need to become fully funded on a conservative measure, so that they can pay all members’ benefits when they fall due.

Why CDI?

Shockingly, within 10 to 15 years, almost all DB pension funds will be cash-flow negative, meaning that they do not have enough income to pay their outflows, such as members’ benefits.

To manage the cash-flow negative problem, most DB pension funds are disinvesting assets to pay pensions. That is not a sustainable solution. If they sell their assets at the wrong time, especially when market values are depressed, and their pension fund is in deficit, they could run out of money fairly quickly or need extra sponsor support.

Other pension funds have opted for their investment mandates to distribute income where possible. However, this is just a ‘stopgap’ because many of those mandates do not usually produce a sufficiently high level of income.

The answer lies with a more optimal approach: it is imperative that trustees and sponsors refine their portfolios and adopt cash-flow driven investment (CDI) strategies that are tailored to their cashflow requirements, allowing room for any uncertainties. That will help produce the income that they need – especially if their pension funds are already (or will soon become) cash-flow negative.

Key considerations

In designing a strategy, three key elements should be considered. The charts below show sample CDI strategies, which vary depending on endgame objectives.

First, the endgame strategy. Each longterm funding and investment objective, including the current funding ratio on which they are based, and the respective timescale to full funding, should drive the design of the CDI solution.

Second, the design. Any good CDI solution must consider factors such as the trustees’ and sponsor’s risk appetite, liquidity needs and certainty of cashflows. Most CDI strategies would comprise assets with contractual cash-flows, such as government bonds and buy-andmaintain credit. However, especially if there’s a pension deficit, there should be appetite for assets that produce cashflows with a high degree of certainty but may not be guaranteed. These could include quality global equity income assets that have low volatility and pay healthy dividends.

A well-designed CDI solution enables trustees and sponsors to adopt a thorough integrated approach across investment, funding and covenant. The investment strategy, along with the assessed strength of sponsor covenant, should determine the appropriate discount rate for liability valuations. Higher yielding assets, reflected in discount rates, would help ease the funding burden.

Finally, there are implementation considerations. It is important for all parties to consider how they manage key pension and investment risks associated with the sponsor, assets and liabilities. For example, there could be unanticipated changes to sponsor solvency, interest rates and inflation expectations. Precise matching is not viable, especially when there is cash-flow uncertainty due to, inter alia, liability management exercises (such as transfer incentives to members or pension increase exchanges) and buy-ins.

2020 and beyond

Coupled with the backdrop of the dismal outlook for interest rates in the UK and the eurozone, strategies focused on generating income need to be a key feature for DB pension funds in 2020 and beyond. The result should be an increase in certainty of returns, reduced funding level volatility and cash-flow needs being met as DB pension funds approach their endgame.

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