Cashflow Driven investment Blog Series - Part 2
How to approach Cashflow Driven Investment
11 Jan 2018 - Estimated reading time: 5 mins
In the first instalment of our blog series we explained what Cashflow Driven Investment (CDI) is. In this instalment we'll look at how to approach CDI.
There are various ways, with differing levels of risk, to generate the required level of cash each year to meet the benefit payments from DB schemes.
As a starting point, it is perhaps easiest to think of the lowest risk scenario where we can pretty much guarantee that we will have the cash required each year. If we had enough money (and if the range of instruments were available), we could buy a portfolio of gilts that would generate the required cash every year through a combination of regular coupons and maturity payments.
Returning to the example of cashflows for a typical scheme which we gave in the first blog in this series - if we take the 30 year point as an example, the cashflow required that year is c£60m for this scheme.
If we want certainty of having that cash, today we can invest in a gilt due to repay £60m in 2047. That gilt will in practice pay us an income of 2% each year (c£1.2m) from now and for the next 30 years, which we can set against the benefits for each previous year. For example in year 10 we need c£20m to meet benefits and the gilt we have just bought will pay us £1.2m of that, leaving us to buy a 10 year gilt for the balance of £18.8m. We can do this for every year all the way out to construct a portfolio of “risk free” (but expensive) assets to match each future cashflow. That is what CDI means in its lowest risk form.
A gilt or other bond is an arrangement whereby we lend money to a borrower for an agreed period. In exchange we are promised a regular income payment and return of our capital at the end of the period. These are known as “contractual cashflows” because the loan contract is based on us receiving those payments in future. The risk to us, depending on who we lend to, is that the borrower will “default” on the agreement and not pay one or more of the agreed payments.
The advantages of contractual cashflow investments is that we know (subject to default) that we will receive the agreed payments, regardless of market conditions. That is a huge benefit for a pension scheme as it ensures that we are never forced sellers of any asset in the event that markets move against us. So that, whatever happens to equities, bond yields or property prices, we know that we can meet the cashflows as they fall due. Sounds easy, and it is if we have enough money!
The lowest risk approach is lending to the UK Government, essentially because the UK has a central bank and can print more gilts to pay us back in future if necessary. The benefit of this approach is that we can be as certain as possible that we will get those payments from our gilts. But gilts are very expensive and not many schemes can afford to invest solely in these assets. UK schemes would need another c£800bn on top of the c£1.5tr of assets they hold to be able to invest that way.
Other contractual cashflow assets
So we need to find other assets which can generate higher returns but with the same contractual cashflow characteristics. Another way of achieving this is to lend to businesses rather than the Government. That introduces the additional risk of the company defaulting - in other words not being good for all the income and maturity payments they have promised. However, that risk can be manageable with the correct precautions in place. High quality corporate bonds generate an extra income of c1% pa in excess of gilts. So if schemes were to invest fully in these assets, they would need less cash - in fact £200bn rather than £800bn. This means, on average, schemes can invest in relatively low risk assets and can expect to meet the expected cashflows each year, provided sufficient deficit contributions are paid to cover the IAS19 deficit.
And we can go further and lend money directly to small and medium sized enterprises (SMEs). As we are taking more risk, we can ask for more income as compensation. Many schemes use this sort of loan to access the contractual cashflows they need, accepting that there is a higher level of risk, but less than investing in the shares of such businesses.
Unfortunately it is not as simple as that – nothing in pensions is ever simple! There are not enough of these types of bonds, and they are not long dated enough to meet the benefit payments many years from now. However, we can use other instruments to create similar exposures covering the vast majority of the benefit payments, so we can get very close to this solution for many schemes.
Many other asset classes also generate income which can be taken into account in a CDI solution. For example, equities pay regular dividends and property or infrastructure holdings pay rentals. The main difference is that we introduce uncertainty at varying levels. Dividends are not guaranteed and may not be paid, there is no fixed value for the underlying equity and no fixed date on which we receive the proceeds. Property is similar in that tenants can default and capital values fluctuate depending on market conditions. Infrastructure is more certain but risks remain. That doesn’t mean such assets should not be included within portfolios - indeed they might have to be included in order to generate returns to meet funding deficits. But we should be aware that the cashflows are less guaranteed than in bonds and loans.
Schemes can construct a portfolio which ensures that they can meet the future benefit payments. The better funded the scheme, the more can be invested in contractual cashflow investments (corporate bonds, loans and other types of debt). That is beneficial because, subject to default risk, the scheme then knows that it can meet its liabilities each year. And crucially, the scheme is not exposed to short term market falls. So if we can manage default risk we can achieve the ‘holy grail’.