In June 2018, The Bank of England kept interest rates at the current level of 0.5%.
The Bank of England voted 6-3 to keep the base rate as is. A few months ago, the consensus was that there would be a rate rise with the market already pricing one in! The timing of future rate rises is also increasingly uncertain, and it feels like a good time to revisit what impact this is having on defined benefit pension schemes.
For example, low interest rates mean Cash Equivalent Transfer Values (CETVs) – the transfer value from a final salary scheme – remain high. Great news for the member, but not so good for the scheme that must fund it. Large pension payments coupled with material CETVs, will result in more and more schemes becoming cashflow negative. These increasing cashflow requirements, coupled with chronic underfunding, turns up the heat on scheme sponsors. Growth assets may deliver the targeted returns in the long-term however, several years of poor returns may drain a scheme’s assets to the extent that meeting long term funding targets becomes a remote possibility.
Therefore, an investment solution is required to ensure suitable liquid assets are available when required to meet these benefit payments.
Cashflow Driven Investment (CDI) presents a viable solution for those waiting for interest rates to rise before increasing their exposure to ‘protection assets’. A diversified portfolio of growth assets may offer a more attractive return potential but can carry too much risk over such short periods. CDI can help mitigate this short-term risk.
A relatively new breed of credit based pooled funds could offer the best of both worlds. These provide a degree of extra return above cash plus predictable cash flows that mirror the short-term benefit outgo. The cash flows are sculpted from the coupons and redemptions of a combination of gilts, global buy-and-maintain credit and amortising multi-asset credit, plus derivatives to fill any gaps.
A CDI strategy does not necessarily need to be at the expense of a Liability Driven Investment (LDI) strategy which has long been a practical tool to help remove the volatility in results and provide interest/inflation risk protection. In combination, LDI can manage interest rate and inflation rate risk, whereas CDI can deal with the short to medium term requirements.
Furthermore, it would be negligent to ignore the significant role that equities can play in generating cash flows to meet future benefits. From a valuation viewpoint, equities are risky relative to a liability as there is no easy way to create a liability-matching strategy using equities. However, equities concentrated on both yield and stability can be used to meet pension benefits over time as well as providing growth. At Quantum, we have clients with a wide array of investment attitudes, including some that prefer investing heavily in equities and high-yielding growth assets to meet their future liabilities.
In summary, there is not a one size fits all solution and CDI is not necessarily suitable for all. However, they are a valuable option that we feel all schemes should consider.
If you are interested in exploring how a CDI strategy may work for your Scheme, please feel free to contact us.
Kanishk Singh, Consultant at Quantum