Cashflow-driven investing: a new approach for reliable, predictable income
In the current environment for liability hedging, maturing defined benefit pension schemes should look at alternative strategies, including cashflow-driven investing, writes John Dewey.
While liability-driven investment (LDI) and growth approaches will remain a key part of the toolkit for defined benefit pension schemes, there is a strong case to be made for incorporating cashflow driven investing (CDI) into their strategies. CDI can deliver the predictable returns of LDI strategies but at higher yields, while diversifying portfolios and drawing on a wide range of return premia.
Traditionally, market returns from assets such as equities, property or diversified multi-asset portfolios have been called on to do the heavy-lifting of generating the long-term returns to overcome deficits. But the challenging outlook for many asset classes raises questions over their ability to continue to single-handedly fulfil this role. Furthermore, experience has demonstrated that a simplistic diversification approach of investing across listed markets can fail to deliver protection when it is most needed: when volatility is high, asset prices are falling and correlations rise.
Even if growth assets might deliver the returns targeted in the long-term, mature pension schemes are juggling the challenging combination of rising cashflow needs and persistent underfunding. This has placed greater emphasis on the risk of path dependency: the possibility that several years of poor returns may deplete a scheme’s assets to the extent that meeting long term funding targets is unviable; putting pressure on corporate sponsors.
For cashflow negative schemes, successful investing in growth assets also relies on the order in which returns arise. Good returns followed by bad returns allows a scheme to build its funding level, pay benefits and weather difficult subsequent market conditions. Conversely, poor returns in the near-term could put the scheme in a more vulnerable position later on.
Kicking the usual bucket approach
The conventional investment approach sees pension assets split broadly into two categories: growth assets, invested to generate strong returns in a diversified pool, and matching assets, used to hedge a scheme’s liabilities in line with movements in interest rates and inflation. But the return outlook for both matching assets and growth assets has been in long-term decline, while deficits remain stubbornly persistent.
Pension schemes should therefore consider a change in investment strategy to exploit assets that may not fit naturally into either growth or matching buckets but will provide reliable income at an attractive premium above bonds and swaps.
- Income-producing diversified growth: A multi-asset investment portfolio of listed assets carefully tailored to pay out a regular income is one way of meeting the cashflow demands faced by maturing pension schemes. This can be achieved by investing in a wide range of asset markets, with a robust strategy to deliver regular, reliable cashflows and protect capital. The success of this approach depends on the skill of the investment manager.
- Customised credit: A credit portfolio can be constructed to meet the cashflow needs of an investor’s liabilities and held to maturity. This provides investors with optimal credit exposure and interest rate, inflation and cashflow exposure tailored to a pension scheme’s liability profile.
- Private assets: Private assets with clearly defined and transparent cashflow characteristics are particularly relevant in this environment; providing higher yields through illiquidity premia and diversified return premia. They include infrastructure debt, real estate debt, private corporate credit and some types of financing transactions that banks are keen to offload from their balance sheets. The optimal assets have bond-like characteristics, but offer better yields and a more reliable means of meeting cashflow requirements with less risk. Infrastructure is particularly attractive, since it can offer highly regulated and secure returns that can reliably deliver annual income of over seven per cent, without leverage.
The middle ground
An investment strategy focused on such assets, generally termed CDI, doesn’t mean replacing growth assets altogether, particularly because it doesn’t provide a perfect match for liabilities when interest rates and inflation change. But it offers an attractive middle ground that can be balanced against traditional approaches, depending on the situation and requirements of each pension scheme.
Pension schemes should clearly understand their time horizon, objectives and cashflow requirements over the coming years to determine the appropriate balance between growth, LDI and CDI. Unlike LDI assets, which offer an effective mark-to-market hedge of a scheme’s liabilities, CDI assets are driven by a wide range of factors, including supply and demand for individual private assets. This offers opportunities to provide cashflows, diversify portfolios to make them more resilient and enhance returns.
If a scheme has a medium to long-term time horizon, and a tolerance for less liquid assets, private assets merit exploration. Conversely, if a scheme is well funded and targeting a buy-in or buyout in the short to medium term, it will typically need a robust mark-to-market hedge and the balance should remain towards LDI.
The next natural step
Cashflow negativity is becoming more prevalent in pension schemes. According to Mercer, 42 per cent of plans surveyed are currently cashflow negative and, of those that are not, nearly 80 per cent are expected to become so over the next decade.
This dynamic highlights why pension schemes should put cashflow requirements at the heart of their asset and liability management strategy. Once a scheme truly understands how its cashflow commitments will change and has determined what allocation it can make to less liquid private assets, it can test those holdings in multiple scenarios and stresses to fully understand how the portfolio will perform in any conceivable environment.
An evolution to CDI represents a natural step for a large number of maturing pension schemes and should lead to a more effective investment strategy in the challenging years ahead.
 Source: European Asset Allocation Survey 2016, a survey of nearly 1,100 institutional investors across 14 countries, reflecting total assets of around €930bn.
For professional/institutional/wholesale/qualified investors only. Not to be distributed to, or relied on by retail investors.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 14 December 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St Helen’s, 1 Undershaft, London EC3DQ. Authorised and regulated by the Financial Conduct Authority and a member of the Investment Association. Contact us at Aviva Investors Global Services Limited, No. 1 Poultry, London EC2R 8EJ.
This article is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited and its subsidiaries Aviva Investors Securities Investment Consulting Co., Ltd. and Aviva Investors Pacific Pty Ltd (“Aviva Investors Asia”) for distribution to investment professionals only. Please note that Aviva Investors Asia does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia in respect of any matters arising from, or in connection with, this document.
Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and is an Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.
Aviva Investors Securities Investment Consulting Co., Ltd., a company incorporated under the Company Law of the Republic of China with registration number 53097616, holds a valid Securities Investment Consulting Enterprise (SICE) License to carry out Securities Investment Consulting Service and other relevant business permitted by Financial Supervisory Commission, Executive Yuan, R.O.C. and provides permitted liaison and co-ordination services only. Registered Office: Room D-1, 24F, No. 7, Section 5, Xin Yi Road, Taipei 110, Taiwan.
Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 50, 120 Collins Street, Melbourne VIC 3000, Australia.