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Cashflow Driven Investing

In our last blog, (written just before the Summer break), we highlighted the rising attention being paid to UK pension schemes’ next, looming challenge i.e. negative cash flow.

To date, recovery contributions have alleviated the need for action for many of them. But as contributions shrink (due to longer spreading periods and / or smaller deficits) and schemes mature, negative cash flow is becoming a real issue and an investment solution will be required.

Which explains why cashflow driven investment (CDI) is the latest obsession of the pensions chattering classes. We see two facets to this, each of which is covered below.

The primary cashflow poser is how to meet benefits over the next five to seven years without fear of realising assets at depressed values:

  • At one extreme, cash offers a solution. But this comes at a high price in the form of the low returns on offer from this safest of asset classes. At the other extreme, the attractive return potential of a diversified portfolio of growth assets might carry too much risk over such short periods.
  • Enter stage left a new breed of credit based pooled funds. These provide a degree of extra return above cash plus predictable cash flows that mirror the short-term benefit outgo of a typical UK pension scheme.
  • 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.

Moving further out in time the cash flow risks become less acute. So much so that, for many schemes, “leveraged LDI plus diversified growth” will provide a good strategy. Nevertheless, investments with predictable cashflows will have a useful role to play in this space too:

  • What are known as “secure income funds” offer reasonably predictable cashflows over reasonably long durations, often with a degree of inflation protection too.
  • These funds include assets such as long lease property and infrastructure debt, the illiquidity of which spawns a not insignificant yield kicker.
  • Over medium-term timeframes, the value of these investments can have a reasonable correlation with “end game” liability values such as buy-out policy prices. Which is why they can be thought of as “insurance led” solutions.
  • Whilst the chances of an insurer accepting a scheme’s secure income assets in specie might be small, the cost of realisation can be minor in comparison to the additional returns they might generate during the investment phase. What’s more, they are increasingly seen by larger schemes as the basis of a DIY buy-in, alongside some protection against members living longer than expected (such as a longevity swap).
  • Finally, but importantly, the chances of tPR looking sympathetically at an “assets return minus” valuation methodology will be increased by the adoption of an investment strategy that emphasises predictable, long dated and inflation linked cash flows.

Our View: Cashflow aware investing might well be an old solution to a new problem, but it makes a lot of sense. What’s more, whereas these simple assets have been difficult for small and medium sized schemes to source in the past, it is pleasing to see the opportunity becoming more widely available.