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Industry Voices

Commentary: An alternative to extending pension plan duration – cash flow-driven investing

U.S. corporate pension plans have struggled to boost average funded status levels during the extended equity bull market, as strong equity returns have been offset by historically low interest rates. This environment, along with a flattening yield curve, has impeded corporate pension plans' ability to increase portfolio yield from fixed income by simply extending duration.

Consequently, some pension plans have resisted allocating more to liability-driven investing strategies as a way to derisk. But sponsors might be overlooking another way to boost yield within their fixed-income portfolios: the use of cash-flow-driven investing.

An LDI alternative

Plan sponsors assessing whether it's the right time to commit to a long-duration LDI strategy might want to consider a CDI approach to meet short-term cash-flow needs. This strategy allows pension plans to maintain a sizable allocation to return-seeking assets, if desired, while adding fixed-income assets to the front end of the curve to match near-term liability outflows. It allows plans to take advantage of the flattening yield curve, and is designed with the potential to mitigate the risk of needing to liquidate assets to fund benefit payments. While not a traditional LDI approach, CDI might provide a transitional opportunity before full LDI implementation.

Multisector opportunities

Sponsors could look to CDI portfolios constructed with the intention of providing cash flow from coupons, maturities and pay-downs over each period immediately prior to a required outflow. The breadth of fixed-income offerings across the curve broadens the universe of investment opportunities that might provide needed cash flows while maintaining portfolio diversification. With this multisector approach, plans gain the potential to generate additional yield over the standard private pension discount curve, which references AA corporate bonds. The potential additional yield is sought through investments in investment-grade corporate bonds, structured finance, high-yield corporates and emerging markets debt.

Investors looking for enhanced yields might want to consider a CDI portfolio with higher allocations to high-yield corporate and emerging markets debt, and to also include allocations to bank loans and distressed debt. The opportunity for enhanced yields with this approach means the risks are higher, given lower liquidity, higher cash-flow uncertainty and increased credit risk. These risks must be considered during the portfolio construction phase with the goal of reducing the potential that asset cash flows fall short of plan outflows.

Exhibits 1 and 2 provide examples of two hypothetical CDI portfolio allocations — a traditional CDI portfolio and an enhanced-yield CDI portfolio — to demonstrate the range of fixed-income sectors that can be used to support plan cash-flow needs.

Transitioning to LDI

The implementation and continuation of a CDI approach can mean periodically funding the strategy with contributions or reallocating from other asset classes to maintain a rolling matched cash-flow period. This longer-term approach to extending the cash-flow match potentially allows plans to transition into a more traditional LDI approach if yield opportunities and plan funded status improve over time. Exhibit 3 demonstrates a hypothetical pattern of sources of cash flow needed to meet projected plan outflows. The contributions may be deployed into CDI or LDI, depending on the plan's funded status and desired investment strategy.

Plan sponsors have other options

Plan sponsors seeking to increase their fixed-income allocation but concerned with committing to long-duration assets at perceived low yields can consider a CDI approach that is designed to meet-short term cash flow needs. Today's flattening yield curve presents an opportunity for plan sponsors to implement a CDI strategy, with the potential benefit of mitigating the risk of needing to liquidate assets to fund pension plan outflows.

Jeff Whitehead, based in Cedar Rapids, Iowa, is the head of client investment solutions for Aegon Asset Management U.S. 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.