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.