Cash flow gets new attention from DB plans

Executives at pension funds, money management firms and consultants are increasingly focused on cash flows, as defined benefit plans mature and face the prospect of having to sell assets to satisfy cash calls.

Sources said the issue is particularly acute in the U.K. and the U.S., with aging populations and the natural cycle of a pension fund reaching, and in some cases at, an inflection point.

“We are seeing more and more schemes beginning to adopt a cash flow focus,” said Calum Cooper, Glasgow, Scotland-based partner and head of trustee consulting at Hymans Robertson LLP. “It is a healthy complement to looking at what balance sheet growth and protection a pension fund needs.”

“This is also a trend in the U.S., where there are an increasing number of public defined benefit systems moving into a negative cash flow situation,” said Steven J. Foresti, chief investment officer at Wilshire Consulting in Santa Monica, Calif.

Research last year by Goldman Sachs Asset Management showed 82% of S&P 500 companies' defined benefit funds are cash flow negative, and a study of U.K. FTSE 350 funds showed 57% are cash flow negative.

Further, the Office for National Statistics' latest data show a £31.1 billion ($38.8 billion) net disinvestment by U.K. institutional investors in the 12 months ended Sept. 30.

Sorca Kelly-Scholte, Europe, Middle East and Africa head of pensions solutions at J.P. Morgan Asset Management in London, said it could mean investors are liquidating assets to service negative cash flows; they might also be parking assets in cash to lock in high equity returns, or in anticipation of other opportunities. However, she added: “We are now on the cusp of seeing many funds going into negative cash flow.” A bounce in inflation over the next year or two could “be the final thing that tips it over the edge,” she added.

The issue is exacerbated in the U.K. by increased flexibility in the retirement market, with participants no longer needing to purchase an annuity to provide income in retirement.

“That in itself introduces more cash flow volatility,” Mr. Cooper said. “You are never going to be able to anticipate perfectly what cash flows you need — that is why it is important to make realistic assumptions,” and, doing so using a live stream of data from administrators and looking quarterly at cash flows to ensure there is no forced selling of assets.

Consultant Mercer Investments is also seeing the trend. “It is unsurprising that cash-flow-driven investment is becoming more popular — especially for trustees that want more of a focus on the payment of benefits and less on mark-to-market risk,” said Tim Banks, London-based senior fiduciary consultant at the firm. “It is an intelligent way to invest if you are targeting self-sufficiency rather than a buyout.”

Mercer has a number of clients already using this focus, with a strategy designed against an individual fund's cash flow needs. “In 2016, which was a very turbulent environment for scheme funding, our clients' funding levels were impressively boring,” added Mr. Banks.

Focusing on cash flow calls for a different asset allocation mindset. “The trend toward negative cash flows has important implications for asset allocation decisions and risk-taking, generally diminishing a plan's tolerance for market volatility,” said Mr. Foresti. “These cash flow trends are causing many institutions to revisit their asset allocation targets. A negative cash flow situation can erode one of the biggest advantages most institutional investors can otherwise exploit: the ability to stay invested over the long term.”

And taking a cash flow approach means executives can start building portfolios “from the short end,” said Carl Hitchman, London-based head of fiduciary management at Stamford Associates Ltd. Cash flows in the next 12 months probably call for cash holdings; the next two to three years, short-dated gilts or a cash-plus fund; and “for five to 10 years, maybe more illiquid debt with the aim of harnessing an illiquidity premium. If you are holding illiquid assets, you need to make sure there is some liquidity point along the line to help you align asset and liability cash flows,” Mr. Hitchman added.

Joe Nankof, founding partner, head of capital markets/asset allocation at Rocaton Investment Advisors LLC in Norwalk, Conn., said the firm is observing cash flows turning negative, and an associated focus on liquidity. “Plans for many years shifted their focus from total return to risk management ... which has included an emphasis on more liquid strategies. The emphasis on liquidity will only continue to grow over time as plans' liquidity needs to grow and the attention and appeal (of) risk transfer strategies intensifies,” he said.

Pension fund trustees and executives need to consider a “hierarchy” of assets to redeem and satisfy cash calls. “Nobody wants to be a forced seller of assets, so it just makes sense to match, or at least attempt to match, your cash flow,” said Alan Pickering, London-based chairman of independent trustee firm BESTrustees. “You want to have a list of three or four sources ... to decide which asset” to redeem at any one time. He said a number of pension funds for which he is trustee operate in this way.

The $2.4 billion Chicago Policemen's Annuity & Benefit Fund is dealing with its cash-flow-negative position by focusing on cash-generating investments, said Aoifinn Devitt, chief investment officer.

The recent enactment of a state law requiring fixed amounts contributed to the fund by the city of Chicago in the next five years means the situation has improved. “While structurally negative, our annual shortfall is only $120 million per year,” around 5% of the fund, Ms. Devitt said. “Our current preference is to try to maximize our investment income in the fund in order to bridge that gap, and we believe that we can achieve this without sacrificing our overall return objective” of 7.25% annualized.

Executives have worked to achieve that in three main ways: By focusing on “low-hanging fruit,” collecting the interest payments on fixed income and the dividends in equity holdings. This generates 30% to 40% of the shortfall per month.

Also, executives last summer enhanced private credit exposure, adding a second direct lending manager; and in October issued a RFP for income-generating investments, “focused less on specific asset classes, and more on the outcome that we sought to achieve” — at least a 5% cash coupon per year, and “not too restrictive liquidity.” Executives are also about to fund a hedge fund of funds, which has been repositioned as a high-conviction portfolio designed to deliver a cash coupon of 5% annually.

The overall goal is to “minimize the need to make liquidations in order to make benefit payments, and while the recent additions and repositioning of the portfolio may not generate enough cash to completely bridge the shortfall, we expect that they will greatly reduce our need to liquidate assets to pay benefits over time,” added Ms. Devitt. Greater stability afforded by the legislative change and portfolio adjustments also means executives can restart allocations to a “portfolio with a blend of liquidities and not just focus on highly liquid assets,” she said.

And while the £1.8 billion Oxfordshire County Council Pension Fund, Oxford, is cash flow positive, “we are conscious that there will come a point where this position shifts and fund becomes cash flow negative,” said Gregory Ley, financial manager-pension fund investments, corporate finance at Oxfordshire County Council. He said executives realize changes to the investment strategy might be necessary to accommodate this. Modeling by the fund's actuary suggests the fund will reach cash-flow-negative status in about seven years, but taking investment income into account pushes this out to 20 years. While the fund is unlikely to be a forced seller of assets over the short to medium term, executives will monitor the situation, timeframes and potential implications.