Aon's investment experts explore the growing importance of cashflow management and the role asset allocation strategies can play to support it. Continue reading the whitepaper above to learn more.
Can you meet your cashflows?
As schemes become more mature, cashflow management becomes of increasing importance. This can be managed in a traditional well diversified portfolio or by seeking to invest in assets that generate cashflows to contribute to the liability out-flow. This paper focuses on the latter. Whichever method trustees choose, they should ensure they have a robust policy for different possible outcomes.
The Pensions Regulator (TPR) annual funding statement
In its 2019 annual funding statement, TPR provided guidance on the long-term direction of pension schemes. The statement highlighted that trustees should consider the maturity of their scheme (as well as funding level and covenant strength) when setting or reviewing investment strategy.
For a relatively mature scheme with a strong funding level and covenant, the guidance was to structure the investment strategy to:
“recognise the shorter time horizon, as well as the interplay between volatility in asset prices, investment returns and benefit outflows. Consider your forward looking liquidity requirements in the light of expected transfer value activity.”
The focus on scheme maturity emphasised the importance of liquidity and cashflow management, given mature schemes tend to have high cash outflows.
When considering a cashflow management strategy, trustees should be aware that there are two standard approaches to meeting payments: disinvestment from liquid assets and/or using contractual income. Both options can be equally appropriate to meet benefit payments and, therefore, the chosen strategy should reflect trustee beliefs / objectives and be chosen with awareness of the risks. In this paper we highlight the route of constructing a strategy using an income approach.
Contractual income portfolios tend to be more appropriate for Schemes which are:
- Relatively well funded with a relatively low return target, and
- Targeting self-sufficiency rather than buyout in the short to medium term
What does it mean to have a mature scheme? This is illustrated by looking at two example schemes. The first is relatively immature, with 30% of its liabilities in respect of pensioner members.
The first chart below illustrates that, for this example scheme, approximately 20% of its cashflows will be paid out of the scheme in the next ten years.
However, if we compare this to a relatively mature scheme (second chart below) with 70% of its liabilities in respect of pensioner members, we expect that 45% of its cashflows will be paid out of the scheme in the next ten years.
This effectively means that the mature scheme has a half-life of just over ten years or put another way, the trustees will have discharged 50% of their current obligations in just over ten years.
In practice, the majority of schemes are currently maturing significantly faster than their cashflow profile would suggest, simply due to members taking tax-free cash at retirement and transfer values and hence cash would be required in excess of the amounts illustrated.
How do I know if my scheme is mature?
In our experience, trustees often underestimate scheme maturity. In the table below, we have included our suggested maturity scale to help you assess the current position of your scheme.
As the maturity of a scheme increases, the ease of predicting cashflow increases and consequently, fewer liquid assets are required to meet unexpected cashflows. Investing in assets which may be less liquid but which provide contractual income can then become an appropriate strategy.
Contractual income assets
Contractual income assets can generate stable returns and cash distributions which a mature scheme can use to meet pension payments.
Secured income assets come in three broad categories:
1. Investment grade credit - such as corporate bonds and Asset Backed Securities (ABS)1.
2. Higher yield credit - such as high yield corporate bonds and ABS, emerging market debt2 and bank loans.
3. Illiquid income - such as long-lease property, real estate debt, infrastructure debt and direct lending.3
Investment grade credit assets provide a stable source of income but are on the lower end of the return spectrum. Generally, as the expected return increases, either illiquidity or risk rises and cashflows become less predictable. Illiquid income assets can provide relatively low risk high returns with a trade-off of unpredictable cashflows. The balance between these factors and how the assets are structured will depend on return/income requirements and liquidity preferences, together with availability and pricing of assets at any given time.
The lower the return/income target the more that can be invested in investment grade. The higher the return/ income target the more that will need to be invested in higher yield and/or illiquid assets. Ideally, trustees should be flexible regarding which of these assets to use at different times.
The long investment time horizon for schemes targeting self-sufficiency should mean trustees are comfortable with illiquid assets.
A portfolio can be constructed using a combination of contractual income assets to match the required return/income target.
We illustrate below what that portfolio might look like in practice.
The portfolio illustrated below would be anticipated to match the first ten years’ cashflows and (if longer dated assets such as infrastructure debt were utilised) a proportion of the anticipated cashflows for the next 10 to 20 years.
The initial cashflows illustrated here are anticipated to be higher than the standard cashflow profile would suggest. Additional cash can be either reinvested or used to help fund liability management exercises such as transfer values or early retirement which would reduce the ultimate liabilities.
This is an example of a contractual income portfolio and monitoring the liquidity of the portfolio will be key to ensuring the robustness of the strategy.
Modelling a scheme’s cashflow requirements helps trustees visualise the scheme’s cashflows over time. We follow a four-step process to help trustees plan for the future and set a robust investment strategy:
1. Identify potential liquidity issues.
2. Determine the impact on the scheme’s asset allocation over time (for example as illiquid funds distribute cash back to the scheme which is then reinvested):
3. The evolution of the asset allocation will influence the expected investment return and therefore the projected time to full funding:
4. Testing resilience
Stress testing is an important way of determining the resilience of an investment strategy to changing situations in terms of cash requirements from the portfolio or market movements.
It is an effective tool to help develop a robust strategy that will enable the trustees to achieve their long-term objectives – fundamentally, of meeting the members’ benefits as and when they fall due.
1 See our paper “Securitised Credit”
2 See our paper “Actively Emerging – Opportunities in Debt”
3 See our paper “Understanding European Direct Lending”
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