Cash flow-driven investment has grown in popularity as defined benefit schemes mature and funding improves. Here are some of the things trustees should consider when trying to match their scheme's cash outflows.

 

The majority of private sector DB schemes are now closed to new members, with 47% also closed to accrual, making them increasingly mature. Some schemes are well or very well funded; the PPF 7800 index hit a funding ratio of 100.8% on a PPF basis at the end of February, even as more than half of schemes were still in deficit.  

 

And with a much greater proportion now well funded on a technical provisions basis - on aggregate at 93.4% for the regulator’s tranche 13 schemes - they may quickly find themselves in cash flow negative territory once the employer ceases to make deficit repair contributions. Trustees will need to consider how to make monthly pension payments without becoming forced sellers at inopportune times. 

 

 

 

 

This conundrum has led to the emergence of cash flow-driven investment strategies, which aim to produce regular cash by investing in income-yielding assets, and to more or less match pension schemes’ outflows when liabilities fall due.  

 

This could in theory be done through a relatively simple laddered bond portfolio; but with interest rates at historical lows, such an approach would be expensive, and so CDI tends to include a variety of other asset classes that provide regular income, from infrastructure to long lease property. 

 

Investing in CDI is a maturity-based decision, says Nadeem Ladha, a professional trustee at 20-20 Trustees.  

 

“For schemes that are getting contributions from the employer, what is your plan once that stops? You need to find another source of liquidity,” he says. He advises trustees not to leave investing for income too late; thinking about how CDI can be implemented should be considered before the contributions dry up. “If a scheme is relatively well funded and mature, it’s difficult not to go into CDI,” he argues. 

 

This might be the case even where a scheme ultimately targets buyout. “If you have a lot of deferred members, there’s no point buying out at that point,” he explains, as insuring deferred members is expensive. If, however, a well funded scheme decides to wait with going to market for buyout until more members retire, it will have to find a way to invest for self-sufficiency in the meantime. One of Ladha's schemes invests 100% in debt, as well as some cash, outside of its liability-driven investment portfolio, using private debt to generate additional returns, for example.  

 

Many CDI strategies are focused on corporate bonds while also using infrastructure debt or long lease property. But he says he has even seen income stocks being included in a CDI strategy, despite the higher risk attached to shares compared with bonds.  

 

 

Illiquidity is often cited as one of the possible risks trustees need to be aware of when going into CDI, but are there other factors to consider? 

 

Where a CDI portfolio focuses on corporate bonds, diversification within this is important, Ladha argues. “You want to be extra focused on defaults,” he warns, especially if private market assets are also part of the mix. 

 

While CDI can work for many mature, well-funded schemes, trustees and the pension fund’s consultant always need to assess the risk in these strategies, which can include assets ranging from investment grade bonds to instruments like student accommodation, cautions independent consultant Irshaad Ahmad, who also warns about weakening covenants in private debt driven by high demand. 

 

“Some of the good CDI strategies... are always looking for new things to add, to help to diversify the risk. It won't be reliant on a single stream of long lease or ground rents,” he explains. 

 

Overall, trustees should consider what CDI is doing for their fund in terms of helping to pay pensions, and whether the risk can be articulated “in plain English”, he says, adding: “That applies to any investment.” 

 

 

Before a scheme invests in CDI at all, it should consider which assets it needs to hold and only then ask if they could be arranged in a CDI way, says Soraya Kazziha, head of client solutions and analytics, EMEA, at PIMCO. “Once that’s done, then you can think about whether those asset classes that are in this mix lend themselves to being structured in a cash flow aware approach,” she adds. 

 

Kazziha advocates investing in CDI using a benchmark, to track if it delivers the required income and provide the ability to generate extra value. "When you’re cashflow negative you can’t really afford to leave any money on the table,” she notes. 

 

Mature schemes are likely to have an LDI portfolio, and trustees will therefore also need to think about whether they want their portfolio to be more CDI or more LDI-focused and how the two interact. 

 

LDI and CDI sit side by side, says Kazziha, because CDI on its own does not provide inflation hedging for the liabilities. Mature schemes will need gilts and swaps to hedge interest rate risk, which is what an LDI portfolio can provide, meaning CDI and LDI complement one another.  

 

“How do they talk to each other? It's quite simple, we do that in a lot of our portfolios. From the CDI portfolio you can produce the granular interest rate exposure,” she explains; the LDI portfolio will then hedge the required exposure net of what the credit portfolio brings. This can increase efficiency if the CDI manager is able to provide a detailed breakdown of the exposure with the right frequency. 

 

Despite the close interaction, there is no need to have CDI and LDI handled by the same manager, she says: “I would even venture to say that quite clearly you need different skills to manage properly a CDI portfolio versus LDI." 

 

 

LDI and CDI can work together, agrees Ross Fleming, a partner at consulting firm Hymans Robertson, “as long as it’s quite clear what the objectives of the portfolio are and how to set these”. 

 

He adds that one of the inherent uncertainties of CDI is the fact that cash flows can never be matched precisely, as people might live longer than expected or decide to transfer their benefits by taking lump sums. 

 

This means it is difficult to predict the exact outgo of a scheme, says Fleming, but he believes CDI can give trustees the knowledge that they are investing in assets that will deliver income with a high degree of certainty to help meet benefit payments.  

 

Want to download this guide? Please click below: