Commentary: What could be wrong with CDI?

At its core, cash flow-driven investing is about investing in assets that will, with a high degree of certainty, produce the cash flows required to meet pension scheme benefit payments as they fall due. This aim generally translates into an investment strategy that seeks to harness credit and/or long-term illiquidity risk via contractual, or close to contractual, cash flows (e.g., corporate bond investments).

Arguably, the roots of investing in CDI strategies stem from the ways insurers invest to manage annuity payments and has been variously marketed as absolute-return credit, alternative credit and multiasset credit.

A fully invested CDI strategy can be a perfectly sensible strategy for pension schemes that are well funded on a low-risk basis (such as a risk free plus about 0.5% to 1% annual discount rate), have a higher degree of certainty on their benefit outlays and/or a strong employer standing behind the schemes through harder times.

Arguably, the precise yield achieved on CDI assets matters less for schemes that can afford to meet benefit payments based on the yield on offer. Moreover, investing in non-CDI strategies introduces risks that better-funded schemes do not necessarily need to take if they can meet their objectives with CDI strategies.

That said, there are several schemes for which CDI strategies would be unsuitable. Schemes that still require significant returns should continue to look at the overall portfolio and manage risk holistically — and not let the desire to implement a CDI strategy distract them from achieving their overall objectives.

Trustees should not lie awake at night worrying if they don't have a CDI strategy in place to meet benefit payments as they fall due. Assuming the scheme holds sufficient liquid growth assets, it can always sell return-seeking and liability-driven investing assets or sell return-seeking and LDI assets (noting that LDI assets typically consist of liquid instruments such as cash, gilts, interest rate and inflation swaps) to fund pension payments.

Pension plan trustees should be aware of the potential pitfalls of deploying a CDI strategy, which might result in schemes not meeting benefit payments as intended. Fixed-income assets with credit risk may experience higher defaults than expected; benefit payments could rise above expectations due to shifting mortality rates or as a result of incomplete member data; inflation-linked assets might not precisely hedge pension schemes benefit structures (e.g., capped and floored benefits), while credit risks can be more complex to model, resulting in unexpected asset cash flow profiles.

While CDI can deliver more predictable outcomes relative to other investment strategies, it can also reduce schemes' flexibility to manage unexpected outcomes (some of which have been listed above) without further support from sponsors. Trustees should not forget that reliance on sponsors may still be required even in a fully invested CDI strategy. This reliance presents particular challenges for schemes where the sponsors' strength may deteriorate over time.

On a related but separate note, for those schemes that are within striking distance of a buyout, holding illiquid assets as part of a CDI strategy could complicate the process. So trustees need to be clear on their time horizons for a buyout of the entire scheme.

There is a risk of schemes allocating to CDI strategies at the wrong time in the journey to full funding. In this context, trustees should be aware that credit spreads have tightened dramatically over the last 10 years as the post-credit crisis recovery has taken hold. There is currently a significant imbalance of supply/demand for CDI strategies (from insurers and pension schemes alike), which ultimately translates into less compelling risk vs. return rewards. While it is somewhat mandatory for insurers to invest in such strategies given the regulatory regimes they are governed by, pension schemes are not similarly bound.

That said, it is still perfectly feasible for less well-funded schemes to have an allocation to credit as a diversifier in their portfolios, just not necessarily of significant scale. Return-seeking investments should be chosen from a broad universe of assets and selected on the basis of their expected risk-adjusted returns. Nevertheless, market opportunities may arise where it makes sense to invest in CDI-type assets from a risk/reward perspective.

Trustees should be planning an endgame strategy, but it is critical to ensure schemes invest in CDI assets at the right time in the journey to full funding and understand the consequences of a mistimed entry.

To that end:

• Schemes should carefully consider when the strategy should build up a meaningful allocation to CDI strategies — done at the wrong time in the journey and recovery might not be possible..
• For the right scheme, a CDI strategy can help ensure it remains on track to pay pensions while minimizing the chance of unexpected market events derailing a scheme from this objective.
• CDI is not a buy-and-forget strategy — experience can be different to expectations.

Paras Shah is head of LDI at Cardano, 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.