Cashflow Driven Investing for defined benefit pension schemes

Secure income investing in a low-yield environment Alpha Real Capital 2

Cashflow Driven Investing overview

The path to ‘self-sufficiency’ for defined benefit pension schemes was never expected to be smooth but few Trustees could have predicted the journey pension scheme funding levels have taken since the global financial crisis (‘GFC’). Most pension schemes were not fully hedged against changes in UK interest rates and have experienced significant increases in their liabilities as UK government bond yields (used to discount their liabilities) have fallen and kept on falling beyond what many commentators believed possible (see charts 1 and 2). The rise in liabilities since the GFC, has resulted in increasing concerns about the need to improve returns and generate cashflow to meet member benefits as schemes mature.

Traditional LDI approach Chart 1: UK defined benefit pension schemes assets and liabilities over time (£bn)1 Most pension schemes have been partially protected from changes in UK interest rates by holding nominal 2,000 130% and index-linked government bonds. A significant 120% number of schemes have also combined their 1,600 UK bond investments with derivatives, such as 110% ‘swaps’ and ‘repos’ in order to leverage and match 1,200 100% the shape and duration of their liabilities to better 800 manage liability risks, in what is known as Liability 90% Driven Investing (‘LDI’). 400 80% An LDI approach to portfolio construction divides an investment strategy into two components; one 0 70% that manages liability risk and one that attempts to Sep-07 Sep-09 Sep-11 Sep-13 Sep-15 Sep-17 generate an appropriate level of investment returns Assets (LHS) Liabilities (LHS) Funding ratio (RHS) to meet pension scheme liabilities as they fall due. This LDI approach seeks to enable Trustees to carry a level of interest rate and inflation risk that they are Chart 2: UK government bond yields over time (%)2 comfortable with whilst selecting a set of return- 6.0 UK fixed-interest gilts >15years seeking assets to outperform their liabilities. This, UK inflation-linked gilts > 5years combined with a sponsor contribution schedule 5.0 should give Trustees a path to ‘self-sufficiency’ given 4.0 a suitable level of risk and time horizon agreed with 2.8% 3.0 the scheme sponsor. 2.0

1.0

0.0

-1.0

-2.0 Sep-07 Sep-09 Sep-11 Sep-13 Sep-15 Sep-17

Sources: 1) Payment protection fund PPF 7800, 2) Barclays Alpha Real Capital 3

The rise of Cashflow Driven Investing As underfunded pension schemes mature and with real yields having fallen to circa -1.5% as at 30 Sept 20172, traditional secure income generating assets such as UK government bonds are less attractive from an income perspective. This has resulted in an increasing number of Trustees turning their attention to alternative secure income producing assets, that can be grouped together as Cashflow Driven Investments (‘CDIs’), which in Alpha Real Capital’s view are defined as:

‘Assets which provide an index-linked or nominal, contractual, secure cashflow with a yield pickup over UK government bonds’

CDI can build on the traditional LDI approach of splitting This approach can help to meet the cashflow a portfolio between liability hedging and return seeking requirements of defined benefit pension schemes whilst assets by adding a third section of assets which are also providing a yield pickup over UK government bonds. specifically focused on generating secure income.

The path to self-sufficiency

Required return LDI CDI Asset growth

Liabilities = Assets to + Assets to + Assets to + hedge generate generate x% retur n liabilities cashflow s capital re turn

This paper looks at the what, the why and how of CDI. Identifying assets which Alpha Real Capital considers CDI, why we feel CDI is attractive for pension schemes, and how to assess and invest in CDI.

Sources: 2) Barclays Alpha Real Capital 4

Example Cashflow Driven Investments

The CDIs shown in the table below have been selected volatility (e.g. REITs) that make them unsuitable to be because they all seek to provide a secure contractual classed as secure CDIs. Alpha Real Capital however cashflows with a yield pickup over UK government views commercial real estate let on long leases as bonds. For commercial balanced real estate and suitable CDIs, for example, social real estate assets, REITs, whilst they typically generate income, often the which have Full Insuring and Repairs (FRI) leases cashflows are either not contractual (e.g. PRS and providing contractual income for in excess of 20 years, student accommodation) or are subject to asset price typically with annual CPI or RPI rental uplifts.

Table 1: Example CDIs

LDI CDI Other UK government bonds ✔ Investment grade corporate bonds ✔ Infrastructure debt ✔ Commercial real estate debt ✔ Lifetime mortgages ✔ Commercial ground rents ✔ Commercial balanced real estate ✔ Commercial long lease real estate ✔ REIT/Listed yield co ✔

Portfolio construction – LDI and CDI complement each other

A key difference between LDI and CDI is the 1) Illiquid assets (e.g. commercial ground rents and long categorisation between a liability matching and a lease property) are not instantaneously responsive to cashflow matching investment. changes in real bond yields, so do not provide a direct liability hedge. However, illiquid CDI yields and UK As discussed, LDI portfolios are designed to directly respond government bond yields do tend to be positively correlated to changes in UK defined benefit liabilities, so as real over longer time horizons as the illiquid asset yields government bond yields decline and pension fund liabilities eventually shift to reflect the change in market conditions. increase, so does the value of the LDI portfolio – providing a direct hedge to changes in scheme liabilities (see chart 3). 2) Liquid assets at the other end of the spectrum (e.g. investment grade corporate bonds and infrastructure debt), For CDI however, it depends on the underlying asset and do provide a hedge against changes in interest rates and in particular its liquidity: this exposure should be included within an LDI portfolio.

In terms of inflation, LDI portfolios are typically designed Chart 3: Comparison between LDI and CDI – to hedge this risk. However, with CDI, there is again a changing UK Government bond yields spectrum, with some assets providing explicit inflation hedging (e.g. commercial grounds rents), others providing Liabilities LDI CDI an inflation correlation (e.g. long lease property with 5 yearly RPI (1,4) uplifts), and others providing fixed cashflows (e.g. lifetime mortgages). Interest rate It is important for Trustees to speak to their investment exposure 0 from consultant or investment manager to look through to the liquid CDI underlying CDI to understand to what extent it is hedging investments interest rate and inflation risk, as this will need to form part of the LDI strategy in order to accurately target a scheme’s desired hedge ratios. Change in value/expected value Increase in nominal yields, RPI unchanged In short, LDI provides the majority of a scheme’s interest Decrease in nominal yields, RPI unchanged rate and inflation hedging, whilst CDI generates the cashflow required to meet member benefits.

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Potential advantages of CDI for defined benefit pension schemes

1) Improving portfolio diversification and Further, having a higher cashflow yield also helps portfolio efficiency reduce a Trustee’s governance burden from making disinvestment decisions as well as potentially reducing Assets that generate secure cashflows, have different transaction costs, including commissions and spreads. return drivers to liquid return-seeking assets such as equities. Adding these to a portfolio can improve 3) Increasing security and predictability its risk-adjusted return. For example, increasing a of cashflows portfolio’s allocation to CDI from a combination of LDI and return‑seeking assets has the potential to achieve CDIs generate secure, predictable cashflows (relative the same expected return at a lower level of risk to cashflows generated by traditional return-seeking (or vice versa) (see table 2). assets) which is important in planning future member benefit payments. 2) Enhancing the cashflow yield of the portfolio 4) Yield pickup above liabilities If Trustees shift some of their portfolio from low-yielding LDI they can significantly improve the cashflow yield of CDIs generate a yield above liabilities, unlike government their portfolio, which is particularly valuable for cashflow bonds, which can help to close the funding gap in negative pension schemes. This can help to mitigate underfunded schemes, whilst still providing a high degree the need to sell down more volatile risky assets at of income security. inopportune moments; crystallising losses in a falling market, which can have a significant compounding impact overtime.

Table 2: Potential for lower risk (same risk) with same expected return (higher expected return)

Illustrative portfolio allocation % Traditional CDI: higher return CDI: lower risk

Equities 25% 20% 15%

Core property 10% 10% 10%

REITs 5% 5% 5% Return seeking EMD 5% 5% 5%

Hedge funds 5% 5% 5%

Global credit 10% 10% 10%

CDI Diversified portfolio 0% 20% 20%

LDI Index-linked and nominal gilts, cash 40% 25% 30%

Liability hedge ratio 70% 70%* 70%*

Annualised expected return above liabilities – 10 year 2.2% 2.4% 2.2%

Annual portfolio volatility 7.6% 7.6% 6.7%

* Maintained with leverage Alpha Real Capital 6

Assessing CDI – reward for running various risks

The return on CDIs will typically be Complexity risk – the risk assumed as a result of the additional upfront or ongoing complexity of investing a function of the yield demanded for in CDI. running various risks. Basis risk – the risk that the value of the asset does Trustees should consider the implications of carrying not move in line with the pension scheme’s swap or gilt these risks and what they mean relative to the appropriate based liability benchmark. CDIs carry varying degrees UK government bond benchmark: of basis risk. Analysis will need to be undertaken on the impact of CDI basis risk from switching matching assets Illiquidity risk – the risk of holding an asset that to CDI. cannot quickly be converted into cash at fair market value. This is a reward for investing for the longer term. Pension schemes should be comfortable Chart 4: Assessing CDI – holding a part of their allocation to illiquid assets as example spread over UK Government bonds long as there is enough liquidity in the portfolio to withstand downside scenarios. 4.0% Asset risk – the return attributed to the exit value Excess return 3.5% 1.0% of the underlying asset, the volatility of the exit (if any) value and the potential impact this has on expected 3.0% return. The longer the contracted cashflows, the less significant the asset risk as the income received 2.5% 0.7% Income risk overtime dominates the return from the exit value. Some CDIs remove asset risk by having fully 2.0% 0.7% Asset risk amortising structures. 1.5% Income risk – the security of rental income (covenant/credit risk) is the sustainability of a 1.0% 1.0% Illiquidity risk counterparty’s business model and the ability to replace, or recover lost income in the event of 0.5% default. CDIs target assets with a high degree of 0.3% Basis risk 0.2% Complexity income security based on quality of the counterparty 0.0% and/or collateral.

Additional considerations

The challenge for some CDIs is in asset origination. Trustees need to select investment managers with a compelling origination strategy and track record. ORIGINATION

The requirement for cashflow amongst UK defined benefit pensions schemes and self investing pensioners provides a long term demand for CDIs. For schemes considering buyout, not all CDIs are suitable and consideration

will be needed as to how CDI fits into Trustees’ long term investment strategies. EXIT Alpha Real Capital 7

How to invest? What about governance?

When considering how to invest, Alpha Real Capital CDI is not as tricky from a governance perspective as you have seen a number of different paths taken by might think, with many schemes already invested in forms Trustees: of CDI (think investment grade corporate bonds, long lease property). ●● Dynamic de-risking – some Trustees have included it as part of their dynamic de-risking There is likely to be more of a focus compared to strategy, investing a proportion in CDI instead of traditional assets on the initial set up. However, once LDI when their funding level has outperformed the in place there should be a relatively low governance Recovery Plan requirement, with emphasis on monitoring the strategy to confirm that the hedging is working and that the assets ●● Disinvest from LDI – others have switched from LDI are delivering their cashflows as planned. to get a return pick up, with some Trustees increasing the leverage within their LDI portfolio to maintain the For Trustees that recognise the appeal of CDI but level of interest rate and inflation hedging are cautious to avoid upfront significant changes to the portfolio, a potential solution is to work towards a ●● Disinvest from return-seeking assets and LDI – CDI strategy over time, using incremental changes to some have sold a mixture of return-seeking assets gradually shift the focus towards CDI as a long-term aim. and LDI, in order to try and improve portfolio diversification and efficiency.

Conclusions

Since the GFC, the decline in UK government bond yields CDI target assets that specifically meet these cashflow has left many defined benefit schemes with significant requirements, such as investment grade corporate funding deficits. In the current low-yield environment, bonds, infrastructure debt, commercial real estate debt, mature pension schemes are looking for secure income lifetime mortgages, commercial ground rents and long generating assets that provide a yield pickup over UK lease property. government bonds in order to help meet member benefit The cashflow CDI generates helps to mitigate the sale payments and close funding gaps. of other assets at inopportune moments and provides diversification benefits from accessing alternative return Chart 5: UK interest rates over time (%) drivers compared to traditional investments. Is the current low yield environment the ‘’new norm’’? 18 Alpha Real Capital believe CDI 16 should be considered as part of a

14 FORECAST 12 holistic investment strategy, providing 10 a yield pickup over UK government 8 bonds to help close scheme funding 6 4 gaps whilst generating secure 2 cashflows to help meet member 0 benefit payments as they fall due. 1950 1960 1970 1980 1990 2000 2010 2020 1940

Alpha has developed a number of CDI solutions including the Social Long Income Fund which invests in UK social real estate and the Index Linked Income Fund which invests in UK commercial ground rents Alpha Real Capital 8

Your contacts at Alpha Real Capital

Hugo James Tom Benham Partner, Head of Long Income Associate Director, Long Income +44 (0)207 391 4729 +44 (0)207 391 4731 [email protected] [email protected]

Scott Gardner Adam Hayes-Newington Partner, Institutional Capital Institutional Business Development +44 (0)207 391 4723 +44 (0)207 391 4561 [email protected] [email protected]

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