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Editorial

Be like the U.K., go with the flow

More than a dozen years ago, liability-driven investing jumped the Atlantic to establish a presence in the U.S. that's since grown rapidly. Plan sponsors might well be advised to take a look at the merits of another investing concept that is already well-established in the U.K.: cash flow-driven investing.

Cash flow-driven investing, or CDI, aims to ensure enough liquidity for pension funds to make their distributions, while continuing to generate optimal returns.

With approximately 73% of defined benefit plans of S&P 500-listed companies being cash flow-negative in 2017 — per preliminary data from Goldman Sachs Asset Management — the idea of cash flow-driven investing is growing in popularity as the next import.

For U.K. pension plans, Mercer data show that of plans that were generating positive cash flow last year, 85% will be cash flow-negative within 10 years.

With defined benefit funds in the U.K. and the U.S. increasingly paying out more than they are receiving from contributions and investment earnings, it becomes harder for these funds to allocate ever-larger shares of their assets to illiquid investments. Those illiquid assets have been responsible for a large and growing portion of equity return since the financial crisis.

A dozen years ago, the hot new European import was liability-driven investing, which aims to ensure the projected return on assets meets the future liabilities of a pension plan. As more and more DB plans in the U.S. have closed in the interim, that strategy is commonplace.

Now, as populations age, whether the plans are open or closed, illiquidity is becoming the new challenge.

As markets become more volatile, asset owners are challenged to keep funds productively invested while also securing the liquidity they need to make payments. And negative cash flow can force asset sales, which can lock in losses.

This is true for U.S. corporate plans that are closed, but perhaps more importantly, it is true for public plans that remain open while their demographics shift and an increasing number are moving toward negative cash flows.

Last month, Pensions & Investments reported the $2.6 billion Chicago Policemen's Annuity & Benefit Fund authorized getting out of private equity investments in order to improve the pension fund's liquidity. The fund moved to private credit to provide more liquidity to address a roughly 5% annual negative cash flow.

A core tenet of cash flow-driven investing in the U.K. has been buy-and-maintain fixed income and other income-driven strategies.

In addition to the needs of DB plans, it appears this kind of cash-flow strategy could, if adapted for individual investors, provide an option for defined contribution plan participants seeking reliable retirement income streams.

Remaining fully invested while also generating funds for individuals to live on in retirement, or offering DB plans a way to combat the challenges of negative cash flow, means this could be the newest attractive idea from overseas.​