Cashflow Driven Investment Blog Series - Part 4
Why is CDI such a big deal?
10 Apr 2018 - Estimated reading time: 5 minutes
With emphasis in both the DWP’s recent white paper and tPR’s 2018 Annual Funding Statement, the expectation to have a clearly articulated approach to IRM is stronger now than ever before.
Managing cashflows effectively is a key component of IRM, and becomes increasingly important as schemes mature. If the money going out significantly exceeds the money coming in, without clear plans it can lead to a forced sale of assets from which schemes cannot recover – something all schemes want to avoid.
The growing scale of the problem
75% of FTSE350 schemes are now in a cashflow negative position and this is only set to increase. As more schemes close to accrual, and baby boomers start to retire, the income versus outgo gap continues to widen. As such, by 2030, schemes will be paying out £100bn more in benefits than they will be receiving into the scheme, every year.
This issue has been exacerbated by the introduction of Freedom and Choice. With increasing numbers of people transferring out of DB schemes, even more money is flowing out of DB than expected. Based on current trends, up to 1 in 5 deferred members will have transferred their benefits out of the scheme over the next 20 years – equating to hundreds of billions of liabilities.
Why is it such a big deal?
The following charts demonstrate the impact of forced asset sales. Both show a fairly typical scheme in terms of funding level and recovery plan, but with contrasting strategies. We have assumed a 33% fall in equities over a 4 year period, followed by recovery over the next 4 years and an identical long term return:
Strategy A - 50% equity | 50% gilt
Strategy B - 10% equity | 70% bonds | 20% LDI
Strategy A shows the serious impact of being a seller of growth assets during a market downturn – the funding level does not improve over the long term, objectives are not achieved and the company will be faced with more cash demands at each valuation. In £ terms there would be a deficit of c£50m at the end of the period. By contrast, the alternative strategy is largely unaffected and is in surplus at the end of the period.
This is because the contractual cashflows from the bond assets (coupons and redemptions) are used to meet the income requirements – we get the expected returns from those assets. And the scheme is not forced to sell its equities – they are able to ride out the volatility and generate the required long term returns by avoiding being a forced seller in a downturn.
Remember your ABCs
Our philosophy of structuring Asset portfolios to Back liability Cashflows – ABC – ensures your scheme has the assets to meet the cashflows you need today, up until the last member’s pension is paid.
By putting cashflows at the heart of your integrated risk management plan, in the spirit of the Government’s White paper, you can be sure you are never forced to sell assets when they are cheap, and you focus on predictable, stable sources of income generation. This will keep you focused on what matters - paying members’ pensions.
This blog is Part 4 in our Cashflow Driven Investment blog series. Click here to view the other blogs in the series.