At the recent Risk Reduction Forum, hosted by Professional Pensions, Schroders' Hannah Simons discussed how cashflow driven investment can provide greater confidence of achieving a strategic goal
Irrespective of size, funding level or maturity, defined benefit (DB) pension plans have one common goal: to pay members' pensions in full and on time.
This goal has become increasingly challenging for plan sponsors as members live longer and the market environment has become ever more uncertain.
It is well documented that most of the UK's DB plans are closed to future accrual to help sponsors bring costs under control. As a result, these plans are now maturing, their liability profiles are changing, and trustees are reviewing the appropriateness of their investment strategies.
For some schemes such developments have coincided with an improvement in their funding status, which potentially opens the door for trustees to explore a different approach to their investment strategy.
Search for stability
DB investment strategies typically were based on an equity/bond portfolio composition, the so called growth/matching portfolio. The majority of assets were given over to equities or other growth assets to provide the returns needed to close the funding gap. The allocation to bonds was intended to help reduce risk by matching the future pension payments (the liabilities). ..
Some challenges remain, for those schemes with material deficits then high allocations to growth assets are one of the few ways that the funding gap can realistically be closed.
On the matching side, in the past 15 years, liability-driven investment (LDI) strategies have become popular as a means of matching the liabilities. However the returns on gilts (the tool most commonly used) are insufficient to plug the funding gaps, trustees still need some form of return seeking assets alongside their LDI allocation.
For those pension schemes with less need for growth assets, today's challenge then is to find a portfolio that can deliver suitable returns but with greater certainty of outcome and one that can also complement existing LDI strategies.
Fortunately for trustees, this solution already exists: cashflow driven investment.
CDI has long been the preserve of insurance companies who used a range of fixed income assets to meet their liabilities. Given the similarities between an insurance company's liabilities and that of a maturing DB plan, it makes sense for trustees to explore CDI.
CDI strategies invest exclusively in credit assets and are designed to work alongside LDI as a replacement for traditional growth seeking assets. These credit assets deliver contractual cashflows, the payments are know in advance and therefore provide greater certainty. In addition rather than being limited to gilts like their LDI counterpart, CDI accesses a much wider range of credit assets. By taking on additional credit risk, investors should be rewarded with extra return.
The right mix
The composition of a CDI strategy will be scheme-specific. Endgame plans, liability profile, appetite for risk will all play a part in choosing the best assets for the specific scheme. Before investing trustees need to consider illiquidity, risk and return characteristics, and reinvestment risk.
Fortunately, there is a wide range of credit assets available that can serve different a range of objectives.
At its core, CDI is based on investment in ‘buy-and-maintain' corporate bonds or investment grade credit. These are loans made to more secure companies which therefore provides a higher degree of certainty on the repayments. The scheme receives the regular payments from the bond issuer until their maturity.
For schemes that require higher levels of return their CDI solution can include ‘alternative' credit solutions. These include infrastructure debt, multi-credit, high yield and emerging market debt.
Finally, CDI strategies can invest in ‘evergreen' assets such as absolute return bonds, insurance-linked securities and securitised credit. The proceeds from these investments are designed to be reinvested rather than rolling down the maturity of the portfolio.
It is likely that a CDI strategy will comprise a mix of evergreen and buy and maintain assets at the start of the journey. As the scheme's funding level improves, so the evergreen or higher risk assets are reduced in favour of more investment grade credit. Eventually these too will mature and be replaced by government bonds at which point the scheme can be run on a self-sufficient basis or be bought out.
Conclusion
CDI strategies offer a real solution for schemes looking for more certainty without wanting to sacrifice too much return. As with any investment strategy, CDI will not suit every scheme but for those with a healthy funding level and a maturing profile CDI could be worth a look.
CDI Key principles
- CDI can provide greater confidence of achieving your strategic goal
- Combines ‘contractual' cashflows with credit risk premium to close the funding gap
- Blending different credit assets can deliver higher returns in the earlier years before rolling off leaving an insurance friendly, low risk portfolio
- Full CDI enables schemes to meet all liability payments without significant reinvestment risk.
- Liability Driven Investment (LDI) plays a key part of the solution
- An effective solution requires understanding, planning and on-going oversight and reporting
