Cashflow matching has become a much talked about topic as many closed DB schemes are about to turn cashflow negative. This requires a new approach for managing risks in what effectively has become the end game.
To better grasp these challenges, we describe how past changes to the pension contract have transformed DB schemes from an open with-profit annuity into a closed book of non-profit annuities.
Understanding the past helps us to better manage the end game, which is quite different for a fully funded scheme and a respectively underfunded scheme
It is often stated that for every decision taken in the planning, strategy and construction phases of pension fund portfolios, that all potential impacts be assessed, risks identified and, where possible, managed using an integrated risk management framework.
However, perhaps some of the largest de-risking decisions taken have not always been based on that impact assessment.
Defined benefit (DB) schemes with a funding gap need to take controlled financial and covenant risks to earn a return above liabilities.
For many closed schemes it is sensible to aim for full funding before the scheme turns cashflow negative.
This will make it easier to match the future pension payments and, at some point in the future, target self-sufficiency or a 'buyout' for tailing liabilities.
It's worth going back in time - some 40 years - and seeing how the pension contract has been changed by regulation or closure to accrual. And whether we, as trustees, thought ahead and adapted the investment strategy in a timely fashion with the changes to the scheme.
Decades of investment decisions
DB schemes have seen significant changes to their business model over the decades. Until the mid-1980s, DB schemes had an inflation indexation ambition and were, in essence, with-profit annuities.
A balanced investment fund with relatively stable asset allocation was designed for this business model, since the members bore some of the downside.
With the Social Security Administration Acts of 1985 and 1990, the government gradually transformed the indexation ambitions into legally binding guarantees.
This changed the business model to a non-profit annuity - but the investment strategy did not change.
After the millennium, DB schemes began to close to accrual, mainly driven by stricter accounting rules.
This was a massive change to the business model since DB schemes ended up managing something similar to a closed non-profit annuity book with the sponsor as the sole owner of the tail risk - but the investment strategy did not materially change.
We acknowledge that investment strategies have evolved with a shift from equities to bonds and alternatives, but the change has been slow and often without recognition of the change in the integrated risks of the scheme.
Theoretical advantage with mature DB schemes
An open DB scheme (non-profit annuity) could be viewed as a perpetual Pay-As-You-Go (PAYG) scheme with a large buffer. In a mature scheme with a stable member base, the contributions roughly match the pension payments.
The role of the buffer is to cover the discontinuity risk in the unlikely event that the sponsor defaults.
With employee contributions matching the pension payments, the investment horizon of the buffer is infinite and it is often argued that a static investment strategy would do the same job since, with an infinite time horizon, the long-term risk premium of risky assets can be harvested.
To determine the size of the buffer in the steady state, some argue for using long-term expected returns when discounting the cashflows of accrued rights, while others argue for using gilts.
Viewing an open DB scheme as a PAYG scheme where the buffer has an infinite investment horizon might have worked well in theory, but in real life it has turned out to be more complex:
• Scheme demographics are not static over time. We face an aging population that lives longer and the 'baby boomer' generation has just begun to retire. In addition, productivity growth has been driven by technology resulting in a significant reduction of jobs in the manufacturing industry. This has drastically skewed the age distribution for some schemes.
• Discontinuity risk reflects the probability that a company will go bankrupt during the members' remaining life times. A young member could be exposed to this discontinuity risk for another 60+ years. Over such a long time period, even today's most solid firms could go bankrupt.
• Financial markets are unpredictable and it is impossible to determine what a 'fair' long-term expected return should be. The markets are not mean-reverting and history shows that there have been long periods of different economic regimes. We have been in a low interest environment for a decade and we don't know how long this will continue.
Open DB schemes
The combination of demographics and productivity gains (fewer jobs) in traditional industries means that many open DB schemes are turning cashflow negative.
The largest part of the pension payments will still be covered by member contributions and investment income, but this needs to be supplemented with capital from the buffer.
For an underfunded scheme, taking capital from the buffer to supplement pension payments erodes the scheme's funding level, leading to an implicit intergenerational transfer.
The larger the underfunding of the scheme, the larger the implicit intergenerational transfers within the scheme.
In the case of a sponsor default, the intergenerational transfer is materialised and further amplified by the rules of the Pension Protection Fund (PPF), since active members are faced with a greater haircut of their benefits than retired members.
Closed DB schemes
When a DB scheme closes to new contributions, the PAYG element stops. The scheme is automatically transformed into a closed book of individual non-profit annuities.
The ways to approach risk and/or matching cashflows are similar to the situation of an insurance company managing a closed book of annuities.
The main differences with an insurance company are that the DB scheme do not face the same capital requirements, has no cost of capital and a population with a higher proportion of deferred members.
A closed DB scheme should aspire towards reaching full funding under the buyout valuation methodology. In portfolio construction, the sponsor's covenant must be treated as the complex financial asset that it is.
With a finite investment time horizon, it is crucial for the scheme that the investment portfolio is adjusted to match the cashflow profile. This will have significant consequences for portfolio construction and the investment approach going forward.
Managing a cashflow negative scheme
A scheme that is about to turn cashflow negative in the near-future requires careful integrated risk management. If the scheme is closed and underfunded some important risk and return tradeoffs must be made by the trustees.
The investment horizon in a closed scheme is not homogenous. Each future pension payment has its own investment horizon. Ignoring this, and not adapting the investment strategy to match the timing of the cashflows will underestimate risk.
In other words, cashflow management becomes central since prolonged adverse market conditions could lead to forced selling of assets which would permanently lock in losses.
Aiming for full funding before the scheme turns cashflow negative will make it easier to manage the cashflow profile of the scheme.
However, for a lot of schemes this is not realistic, which means they need to start contingency planning for when they become cashflow negative and how to manage the risk that arises.
Mind the funding gap - the sinking giant's problem
In a closed scheme, pensions are paid in full by withdrawing capital from the buffer.
If the financial return with respect to the liabilities is negative for the first couple of years, this will quickly drain the buffer and the solvency of the scheme.
High returns above the liabilities later in time might not be sufficient for closing the funding gap.
This is often referred to as the sinking giants effect. In this situation, large amounts of cash will be diverted away from the sponsor and potentially hamper necessary investment to maintain its competitiveness.
This is a form of intergenerational transfer from active members to the retired members.
There is also a wider intergenerational transfer, especially for employers with closed DB schemes, as money is diverted from current employees to pay the pensions of former staff.
Do not expect the sponsor to always be there
The recovery plan contains deficit repair contributions which can postpone the time until the scheme becomes cashflow negative.
Deficit repair contributions provide trustees with some leeway, but it is still essential to adjust the investment strategy as soon as possible.
Trustees cannot expect the sponsor to always be there since, if the deficit is becoming too big, it might bring the sponsor down. If the sponsor defaults, then retirees are benefitting at the expense of active members.
More than one road leads to Rome
Defining the journey plan towards full funding requires careful planning, including deficit repair contributions and a robust investment strategy.
Matching cashflows alone will not help since it will de-risk the scheme, and the sponsor will lock in the funding gap, which is a risky strategy for both employees and sponsor.
To close the funding gap, the scheme needs to take controlled financial risk to earn a return above the liabilities. The two common approaches are cashflow matching using physical assets, and matching using overlay hedging.
In the former, the scheme invests in a portfolio of cashflow matching assets that offer a credit spread. This could be unleveraged infrastructure and/or a variety of credit-based fixed income instruments.
In the latter approach, the market sensitivity of the cash-flow is hedged using an overlay. Financial market risk is then taken in a diversified return-seeking portfolio.
Which method to use is a matter of taste and skill since both approaches are just different ways to achieve the same goal - closing the funding gap in a controlled way.
Reflective questions
To conclude, we offer five reflective questions that helped us get a better grip on the current situation. Trustees could use these questions to help them assess the specific situation in their scheme:
• Do you know if you are, or when you will be, cashflow negative?
• Can you realistically close the funding gap before that?
• Is your strategic asset allocation approach able to navigate negative cashflows?
• How sensitive is your current approach to the sequence of future investment returns?
• Do you have a sponsor strong enough to support the scheme if the sequence of returns is adverse?
Will closing a DB scheme reduce the risk for the sponsor?
• Closing a DB scheme is often driven by the objective to reduce the risk to the sponsor. This motivation sounds plausible since it caps the creation of future liabilities, but closing a DB scheme may actually increase the risk for the sponsor:
• Future contributions are linked to the real economy which provides natural diversification to the financial market return on the buffer.
• The draw-down from the buffer in an open scheme is much smaller compared to a closed scheme. This makes it possible for an open scheme to have a longer investment horizon and recoup some losses in the financial markets.
• In a closed cashflow negative scheme, the impact of underperformance can have a significant impact on both the funding ratio and the covenant. This is known as the sinking giants problem.
Closing a DB scheme makes the covenant more sensitive to developments in financial markets and reduces the investment time horizon of the buffer.
Before closing a scheme, we recommend that the trustees and sponsor carefully analyse the potential consequences, particularly how the closure of the scheme would affect the overall level of risk.
About the authors
Ian Maybury is an experienced trustee and actuary. Following an executive career in insurance with Royal London, banking with Citi, investment consulting with Redington and fund management with Schroders, he now holds various trustee and investment/DC committee appointments at BA, Citi, Mineworkers', RNIB, Reed Elsevier, Unilever and USS.
Stefan Lundbergh has unique insight in managing the balance sheet of pension funds, ranging from innovative investment strategies to organisational design and governance, and has supported several governments with pension policy design. Stefan is a non-executive board member of the Fourth Swedish National Pension Fund (AP4). He holds a PhD from Stockholm School of Economics.
