Commentary: Cash flow-driven investing – Keep it simple and straightforward

Pensions & Investments' recent editorial ("Be like the U.K., go with the flow," March 19) raises a key point about asset management, particularly for underfunded corporate and public pension plans: the need to generate sufficient cash flows to pay growing benefits (over and above contributions), while ensuring funded status growth.

This conundrum suggests asset owners need to implement innovative derivative overlay strategies (from managing asset allocation or currency exposures to harvesting volatility premiums), because these strategies improve the governance of unmanaged exposures without changing policy or terminating existing managers, operate on margin, throw off cash if successful (reducing the need to sell assets), and potentially lower the overall risk of the fund.

These strategies are not theoretical. There are corporate and public pension plans that have done this successfully for many years.

However, P&I's editorial hints at a much deeper issue — finance theory underlying portfolio management itself needs to be reconsidered to focus on cash flows, which engenders the need to create financial instruments to greatly simplify cash flow-driven investing.

The growing trend of goals-based investing recognizes that investors hold assets to satisfy key goals — planning for retirement (individual or institutional), saving for a child's education, or purchasing a house or a car. These goals share one interesting, often overlooked, facet: Every investor would like a guaranteed, target level of real cash flows (linked to the inflation of the goal), that starts on a given date and runs for a fixed, foreseeable period of time. For simplicity, consider the challenge of an individual saving for retirement in a defined contribution plan. It is reasonable to assume that the goal of the investor is to receive $50,000 (in today's dollars), when they turn 65, and for that stream to be guaranteed for 20 years thereafter (average life expectancy in the U.S.).

There are two investment approaches to goals-based investing, to achieve this goal.

The traditional/mainstream approach takes existing assets and attempts to create "optimized" portfolios, based on modern portfolio theory. Robo-investing or target-date funds utilize this approach. However, this approach is much more elegant in theory than practice because there are no currently available assets with the desired cash flow profile, and the industry's track record for forecasting returns and other inputs for these models is poor, at best. Moreover, most investors are financially illiterate and do not understand compounding, diversification or the impact of inflation.

These shortcomings make this approach complex, error-prone, expensive and risky. The problem is well beyond the scope of the average investor and could lead to another pension crisis, as individuals are being asked to take control of their investment decisions in DC plans. One could go so far as to argue that the traditional approach to managing even institutional defined benefit portfolios, especially prior to the tech bubble (when many DB plans were overfunded) or the great financial crisis, led to the global decline in funded status. It need not be repeated in DC plans.

The second approach, called the KISS (keep it simple and straightforward) or cash flow-driven approach, takes a very different tack: It recognizes each goal is unique and predominantly about cash flows. Rather than trying to create ever more complex MPT approaches, it focuses on creating goal-appropriate, cash flow-generating financial instruments that investors need, which then trivializes the investment problem and eliminates previously mentioned challenges.

To bring this more readily to defined contribution plan participants, Robert C. Merton, a Nobel laureate and professor of finance at the MIT Sloan School of Management, Cambridge, Mass., and I recommend the U.S. Treasury issue a new "safe" bond instrument — standard-of-living indexed, forward-starting, income-only securities, or SeLFIES. This instrument would ensure retirement security, and the federal (or state) government is a natural issuer, although insurance companies and infrastructure companies could easily issue them as well.

SeLFIES would pay the holder annually for 20 years, starting at a fixed date, a fixed real amount (say $5), indexed to aggregate per capita consumption. Instead of current bonds that index solely to inflation, SeLFIES cover both the risk of inflation and standard-of-living improvements so retirees can maintain a particular lifestyle. A 25-year-old today would purchase the 2058 bond, which would pay the holder from 2058 through 2078. This innovation addresses even the most financially illiterate individual, providing a self-reliant alternative to retirement planning. If the individual targets $50,000 real in retirement, the goal is to buy 10,000 bonds over one's working life ($50,000/$5). The complex decisions of how much to save, how to invest and how to drawdown, are folded into one simple calculation of how many bonds to buy. In addition to being simple to understand, liquid, easily traded at a very low cost and with low credit risk, SeLFIES can be bequeathed to heirs. Buying SeLFIES is similar to creating an "individual DB," with guaranteed cash-flow determined simply by the number of bonds purchased. Individuals could easily change the level of desired cash flows in retirement and the goal is easily recalculated. One can easily see how this cash-flow matching instrument can be created for college savings plans (where now the natural issuers are colleges/universities and the link is to tuition inflation, and the payment is just for four years).

In summary, there are no existing instruments or products that perfectly match the cash profile of various goals. Complex theories have been created to establish optimal dynamic savings, investments and decumulation decisions, but these are error-prone, complex, risky and well beyond the reach of the average population. Maybe Einstein had it right when he stated, "If you can't explain it to a 6-year old, you don't understand it yourself."

We need to make investments easy enough for a 6-year-old to understand, and given the importance of cash flows, with a simple innovation, the KISS approach does just that.

Arun Muralidhar is co-founder of Mcube Investment Technologies LLC, in Great Falls, Va. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.