Commentary: DB schemes: adapting to a cash-flow negative world

With the vast majority of U.K. defined benefit pension schemes forecast to become cash flow negative in the next 10 years, it has become increasingly clear that the next challenge for pension scheme trustees will be cash flow management. Yet with key market events such as Brexit on the agenda, many trustees don't regard cash flow as a pressing concern. That, however, is likely to change as schemes mature further and the amount they need to pay out in benefits increases.

Meeting this challenge will demand a major shift in trustees' mindset. Having spent decades focusing on accumulation of assets and management of liabilities, many must now switch their attention — and the scheme's strategy — toward meeting future cash flow requirements.

Many schemes are turning to relatively new solutions such as cash flow-driven investing to manage cash flow requirements in the short term and as a replacement or penultimate step prior to a buyout in the longer term. In the U.K., CDI has gained popularity as it can help transitioning schemes reduce the need to become forced sellers of assets while allowing them to plan for their cash flow requirements using liquid and buyout-friendly instruments such as corporate bonds. Crucially, CDI not only focuses on acquiring these instruments, it also seeks to restructure schemes' existing assets to ensure they are better suited for cash flow — not return — generation.

The positive news is that schemes are naturally well positioned to transition from their role as return generators to vehicles for distributing cash flow. U.K. pension funds are already among the largest existing investors in the corporate bond market, accounting for about half of total assets. The big challenge is to ensure they have the right investment strategy to make this switch, and it's here that schemes can learn from institutional investors beyond the traditional U.K. pensions industry.

Cash flow has long been central to the insurance sector, and typically companies in this space have taken a "buy-and-maintain" approach to meeting their requirements — diversifying their credit exposure while minimizing transaction costs through lower turnover. U.K. pension schemes, however, have customarily employed traditional passive and active management strategies in their efforts to generate return. Neither strategy is well-suited to cash flow delivery in a world in which corporate bond market liquidity has been in sharp decline due to increased regulation and higher capital requirements. With income from bonds at historic lows, active managers struggle to generate returns net of transaction costs. Meanwhile, passive management — the natural alternative — is riddled with flaws, not least poor diversification and overallocation to the most indebted issuers.

An insurance-like buy-and-maintain approach seeks to avoid the cost and performance inefficiencies of both traditional active and passive management by harvesting the maximum amount of spread in the bond market as cheaply as possible. It aims to invest in fundamentally strong names, thereby mitigating downside risk and the potential impact of market shocks and defaults while minimizing punitive transaction costs. Predictable cash flows, an extra premium over government bonds, duration and relative liquidity make it better placed to sit at the core of a CDI solution and ultimately help schemes meet member promises.

Buy and maintain is, however, an approach that demands a different mentality from the manager of the assets — not only the scheme. Just as trustees will be obliged to shift focus from returns to cash flow, buy-and-maintain credit managers must adopt a different process to traditional active investors, bearing in mind that the bonds within these portfolios will be held far longer than within an active book. From a fundamental credit analysis perspective, investment processes must accordingly reflect the difference in time horizon; incorporating long-term strategies and overarching trends at the name and sector level, as well as — crucially — non-financial considerations such as environmental, social and governance criteria.

As the sterling asset market is highly technical in nature, capacity is an additional factor to consider when looking at the market for CDI-type assets. As one of the biggest investors in the U.K., attention is rightly paid to the potential impact pension scheme investment strategies can have on the asset markets in which they invest. This can be significant. The prominence and growth of liability-driven investing, for instance, has driven long-dated real yields in the index-linked gilt market to levels that few would have thought possible, despite a substantial increase in issuance over the past decade. As a core component of CDI, sterling corporate bonds could also be questioned from a capacity perspective, with derisking schemes likely to continue to buy these instruments at the same time as net supply may decrease as corporates face potentially higher borrowing costs.

While liquidity is indeed likely to decrease over the long term, U.K. schemes should, nonetheless, continue to focus on building sterling-focused corporate bond portfolios as a central holding of CDI-based strategies — not least since they have sterling-based liabilities. However, schemes should also require managers of these strategies to build highly diversified portfolios (across names, sectors and regions); an approach made possible by the fact that many international companies, such as United Parcel Service Inc., issue debt in sterling as well as in their local currency.

Moreover, CDI does not, unlike LDI, depend on buying assets; it also focuses on the cash flow generative assets schemes already hold. While capacity issues should always be considered in the context of wider investment trends, it should also be remembered that U.K. schemes are already major holders of sterling corporate bonds, and they can be managed to meet the changing objectives and challenges schemes face going forward.

Over time, of course, schemes are likely to seek a wider set of opportunities. While most cash flow solutions will be funded initially through sterling investment credit holdings, as schemes continue to derisk and more assets are invested into credit, core portfolios could be diversified to enhance spread and reduce cost. In particular, a core sterling holding could be complemented by overseas credit, credit default swaps, BBB-rated bonds, high yield and less liquid investment solutions that offer higher yields.

Despite schemes having suitable assets to partially manage their benefit payments, cash flow delivery will undoubtedly assume greater importance as schemes mature more rapidly than expected and become cash flow negative. Rather than delay action to tackle this looming problem, schemes should make addressing their cash flow needs a far bigger priority than they are today.

Sebastien Proffit is head of fixed-income portfolio solutions at AXA Investment Managers, based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.