Cashflow Driven Investing (CDI) is an investment approach that helps defined benefit pension schemes with their funding efforts and can increase their likelihood of continuing to meet both their future cashflow requirements and their funding objectives. To generate predictable cashflows, CDI strategies typically focus on fixed interest securities such as high-quality corporate bonds, arranged in a way that minimises the risk of having to disinvest assets at potentially inopportune times in volatile markets. These types of assets can provide stable, contractual income that is paid in line with the expected cashflow requirements of the pension scheme.
The erosion problem caused by volatile returns
As defined benefit pension schemes continue to mature (and in many cases become increasingly cashflow negative) the dangers of having to sell assets at a depressed level, to meet benefit payments, rises.
For example, a very mature defined benefit pension scheme might annually divest 7% of its assets to meet benefit payments. Over three years, this would mean about 20% of the original asset value is sold to meet benefit payments.
Economic and financial market history tells us that market crashes (periods of poor investment returns) are often followed by market booms (periods of high investment returns) and vice versa. It was John Maynard Keynes who first coined the term ‘animal spirits’ to describe the psychological and emotional factors that drive investors to take action when faced with high levels of volatility in the capital markets. Over time, the psychological and emotional factors that impact investment returns can be expected to cancel out, with long-run investment returns ultimately being driven by more tangible, fundamental factors.
However, cashflow negative investors don’t have the luxury of long-run averages. In volatile markets, chipping away a fifth or more of the portfolio’s value during a downswing can seriously undermine the ability of the remaining assets to deliver the returns required to fulfill a scheme’s funding plans.
The CDI solution
One way to manage the significant impact a market downturn could have on future required deficit contributions is to design the investment strategy such that the investor is less likely to be a forced seller of assets. This reduces the risk of having to sell assets when market sentiment (and prices) are low and avoids any potentially avoidable transaction-related costs. A tentative step on this path is to have a portion of the investment strategy invested in fixed interest securities (the CDI piece of the investment strategy), which has a coupon and redemption profile over the short term (say up to 5 years) that matches the scheme’s expected liability payments.
For every year that investment returns are in line with expectations, or higher, a tranche of the riskier assets (non-CDI) can be sold, to fund purchasing additional fixed income securities within the CDI strategy and maintain the expected cashflow matched position over the desired period, which would otherwise reduce every year. During a year when investment returns are poor, riskier assets could be retained rather than sold, and the matched cashflow position would be allowed to roll down in the hope that markets recover before the end of the matched period.
In this manner, the risk that the scheme would be a forced seller of assets at a time when market sentiment dips is substantially reduced, yielding a smoother and less volatile funding position in the future.
For a scheme that is already well-funded on a set of relatively strong funding assumptions, there may be little or no need for continued risky growth asset holdings where its benefit cashflows can be matched with more secure and stable assets generating highly predictable payment streams.
In our view, CDI is a sensible investment approach for schemes to consider but is by no means a panacea for all. Depending on a scheme’s funding position and circumstances, CDI will have differing levels of attractiveness however, the application of the approach is likely to be attractive for almost all schemes facing the challenge of negative cashflow.
For more information on CDI and how Broadstone can help you achieve your goals, please contact [email protected]
Broadstone recently participated at the Camradata CDI roundtable and the white paper is available here.
