How can DB pension schemes make effective use of cashflow-driven investing?

New whitepaper from CAMRADATA explores

With many defined benefit pension schemes becoming cashflow negative in recent years, CAMRADATA’s latest whitepaper on Cashflow Driven Investing looks at how pension schemes can use cashflow-driven investing (CDI) as a remedy for the shortfall of income.

The whitepaper includes insight from guests who attended a virtual roundtable hosted by CAMRADATA in October, including representatives from Aberdeen Standard Investments, Alpha Real Capital, M&G Investments, Barnett Waddingham, Broadstone, Cartwright, SEI and XPS Pension Group.

According to Mercer’s latest European asset allocation report[i], 66% of plans are now cashflow negative, while over half of those plans that are currently cashflow positive can expect to see the tides turn to negative within five years. This imbalance is becoming an increasingly significant challenge for pension schemes to overcome, as trustees look to secure their financial future amidst unprecedented uncertainty.

The report highlights that cashflow-driven investing can be used to try and generate cashflows in order to pay benefits and increase the certainty of securing returns for pension schemes, however, to be effective schemes need to evaluate their goals and how CDI can be suitable for achieving them.

Sean Thompson, Managing Director, CAMRADATA said, “Cashflow Driven Investing is predominantly a bond-focused approach which can be used to try and generate cashflows and increase returns. It can also help reduce funding volatility, but the approach is not suitable for all types of schemes.

“In an environment of low bond yields, the fixed income-focused strategy would not work for pension schemes that are still a long way off from reaching their funding objectives – it’s better suited to those that have made decent headway in reducing their investment risks.

“In the whitepaper, our roundtable guests considered the risks and challenges involved in CDI and look at how DB pension schemes can best use the approach to lower risk and become cashflow positive once more. CDI is not a quick fix – but adopting the method can be a step in the right direction for reducing liability long-term.”

The guests were also asked if for a well-funded, closed DB scheme, they would they like to see the reference benchmark for investments as gilts-plus or a CDI portfolio or some other.

They also discussed the need for smaller schemes to have greater planning, and whether a series of specialists such as Alpha Real Capital or one-stop shops like ASI or M&G worked better in CDI, before turning to COVID overshadowing the economy.

Key takeaway points were:

• As many defined benefit pension schemes are now cashflow negative CDI has become much more important.
• The primary benefit of CDI is increased certainty of outcome. One guest emphasised that for most of their clients, managing short term cashflows was not a challenge. The big uncertainties instead lie five years out and beyond.
• The breadth of research from managers is important because it brings diversification into the portfolio.
• One guest thought that there would be new developments in CDI pooled products and noted that they were working on new pooled CDI products for smaller schemes that would be well diversified by combining public and private debt, next year.
• Allocation to illiquid private assets might not suit schemes that are very close (say two years) to the endgame of buyout, but for many other smaller schemes that are further from such an endgame, private assets could be very helpful.
• They pointed out that the probability of default has gone up. This is relevant to CDI and brought the conversation back to credit research and having the expertise to properly stock pick. Credit researchers these days are gold dust: adding that portfolio managers need real-time updates.
• A final point was made on collaborations, with one panellist pointing out that they had been working with a range of pension fund consultancies, to provide more than just fund management to help clients with their derisking journey towards the endgame. CDI is one path to that ultimate destination.