December 2017
CASHFLOW DRIVEN INVESTMENT (CDI)
MADE SIMPLE GUIDE 2
ACKNOWLEDGEMENTS We would like to thank Schroders for its help producing and sponsoring this guide.
This guide is for information only. It is not investment or legal advice.
Published by the Pensions and Lifetime Savings Association 2017 © First published: December 2017
MS Cashflow driven investment (CDI) 3
CONTENTS
1 Introduction 4 2 What is CDI? 5 3 The relevance of CDI 8 4 Characteristics of CDI 9 5 Which assets does CDI use? 11 6 Monitoring and management 13 7 Conclusion 16 8 Glossary 17
December 2017 MS 4
1 INTRODUCTION
CASHFLOW DRIVEN INVESTMENT (CDI) IS A NEW TAKE ON AN ESTABLISHED The basic principles of CDI have been employed for a IDEA. MANY – IF NOT MOST – DEFINED BENEFIT (DB) PENSION SCHEMES DO long time by insurance company annuity funds. The idea NOT HAVE SUFFICIENT ASSETS TO INVEST ENTIRELY IN GOVERNMENT BONDS of pension schemes adopting a similar but more flexible (GILTS) TO MEET ALL FUTURE PENSION PAYMENTS (LIABILITIES). approach – that is better suited to their needs while not being bound by insurance company regulations – has also been To try and meet this shortfall, a large number of pension discussed for a while. However, CDI has received increased schemes have constructed their investment portfolios to attention recently. This is quite natural since most pension match these payments, as far as possible, with lower-risk schemes are now closed to new entrants and therefore have instruments such as gilts, while using higher-risk assets such a finite lifetime. As pension schemes mature and as funding as equities to grow their capital to fill the gap. levels improve, the focus often shifts towards adopting a A CDI approach, supplemented with liability driven lower-risk investment strategy designed to meet liability investment (LDI), can provide a middle path: with a large payments. This is exactly what CDI is intended to deliver. allocation to assets that provide both growth and matching This guide will explain what CDI is, its building blocks, characteristics and, importantly, overall providing far more who it is appropriate for, and the rationale for using it. In certainty of ultimate outcome. addition, we explain the process of monitoring and validating The main features of a CDI solution are: the solution so trustees can assess whether their chosen CDI solution does indeed do what it says on the tin. We also A large portion of the scheme’s liabilities can be matched provide a glossary at the end of the guide, explaining some of with the income and redemption proceeds from a wide the key terms. range of corporate bond and other bond-like assets offering a yield in excess of gilts; NEIL WALTON Head of Investment Solutions, Schroders A cashflow match and a greater assurance of return than JON EXLEY Solutions Manager, Schroders traditional growth assets; ED STUDD Solutions Manager, Schroders The solution risk profile is tailored to meet covenant constraints or longer-term objectives such as buy-out; and Low governance – once designed and implemented the strategy should lock down a plan to meet the liabilities with limited reinvestment risk.
MS Cashflow driven investment (CDI) 5
2 WHAT IS CDI?
MATCHING LIABILITY CASHFLOWS WITH BONDS Figure 2 below is an illustration of a pension scheme’s projected liability cashflows. These represent lump sums and THE STRATEGY OF USING A PORTFOLIO OF GOVERNMENT BONDS TO MATCH pension payments made to the members throughout their LIABILITY CASHFLOWS HAS BEEN ADOPTED BY MANY PENSION SCHEMES AS remaining life after they retire. PART OF AN LDI PORTFOLIO. Figure 2: A pension scheme’s projected cashflows At its heart, this is based on the logic that a pension scheme’s payments to pensioners are very similar to bond cashflows. A m gilt, for example, offers a number of interest payments along with the final redemption payment that the government has promised to make to the holder of the bond. These cashflows can be predicted and used to match the projected pension- payment liability cashflows of the scheme. Figure 1: Illustrative cashflows from a single 7-year bond b c
e em me 2017 2027 20 7 20 7 20 7 20 7 2077 20 7 20 7 ear
Source: Schroders. For illustration only.
ere e Similarly, figure 3 below illustrates the projected cashflows of a portfolio of long-dated corporate bonds. These cashflows include both the interest income from the bonds and the redemption amounts as the bonds mature. Figure 3: Cashflows from a portfolio of long-dated 1 2 7 corporate bonds ear Source: Schroders. For illustration only. m ere c me r m e b e r e e r In addition to gilts, there are a wide range of other bond assets (see section 5) that also provide contractual cashflows, S e re re e c although they are typically backed by companies or other r m c e b m re entities rather than the government. A CDI solution will model these payments and use them to match the pension scheme’s projected liability cashflows. The only difference c is that the CDI approach must make an allowance for the possible failure of some corporate bond issuers to meet their 2017 2027 20 7 20 7 20 7 20 7 2077 20 7 20 7 interest and capital commitments. However, even allowing ear for these defaults, a CDI portfolio is still expected to earn a return above that available from government bonds alone. Source: Schroders. For illustration only.
December 2017 MS 6
CDI’S RELATIONSHIP WITH LDI GOAL OF CDI CDI involves establishing a portfolio of bonds (or contractual It is important to note that the corporate bonds and other cashflow assets) which: credit represented in figure 4 are assumed to provide a yield in excess of gilts. Figure 5 below shows what would happen If held to redemption (after making a prudent allowance if the pension scheme instead invested solely in government for defaults) are projected to meet all the liability cashflows bonds. These cashflows would not be sufficient to meet the as they fall due; liability cashflows. This would be true irrespective of the Should not require any significant payments into the fund, structure of the gilt portfolio, e.g. if the gilt portfolio was or to sell assets that are already there; and restructured to fully match the nearer term liabilities then there would be a cashflow shortfall (unshaded area) against Could be described as a ‘buy and maintain’ portfolio, given the longer-dated liabilities. the limited need for management. Figure 5: A pension scheme only invested in government However, CDI is not an alternative to LDI and in fact it works bonds through LDI best when it is fully integrated with an LDI solution. For example, the very longest-dated pension liabilities will still m need to be matched with government bonds, as there are no contractual cashflow (CDI) assets readily available at the very longest maturities. In addition, LDI will be required to add inflation exposure to CDI assets to match the inflation linkage of many pension liabilities. In general, the role of b e LDI is therefore to be what might be called the ‘completion portfolio’: complementing CDI by filling in the gaps that it Government onds DI cannot deliver on its own. Figure 4 below illustrates the basic principles. 2017 2027 20 7 20 7 20 7 20 7 2077 20 7 20 7 Figure 4: The basic principles of CDI ear m Source: Schroders. For illustration only.
Pension liabilities are typically valued by looking at what an investor would need to invest now to meet the estimated b e future pension payments. This is done by ‘discounting’ them r r e b to present day values using a suitable interest rate (as defined er cre by a scheme actuary). It is clear in the example above that er me using a government bond yield to value the liabilities in D this way would mean that the pension scheme was not fully 2017 2027 20 7 20 7 20 7 20 7 2077 20 7 20 7 funded (the ratio of assets to liabilities will be less than 100%, ear as implied by the unshaded area in figure 5). However, by investing in corporate bonds, the scheme would be able to Source: Schroders. For illustration only. generate sufficient cashflows to meet the liabilities and thus fill the gap.
MS Cashflow driven investment (CDI) 7
The additional return or ‘spread’ above government bonds means that, for the same £100 invested on day one, more cashflow can be expected from a corporate bond than a government bond, even after allowing for possible defaults. The additional amount can be approximated by looking at the difference in yield between a corporate bond and a government bond in pounds (multiplying this difference by the amount invested) and multiplying that by the number of years for which investors will benefit from that spread (the ‘duration’ of the corporate bond). Combining these concepts determines the main goal of CDI, which is to secure sufficient return or spread above government bonds to meet all liability cashflow payments. CDI GOAL: SECURE THE RETURN ON A PORTFOLIO OF BONDS AT THE OUTSET WHICH IS SUFFICIENT FOR THE ASSETS TO MEET ALL PENSION LIABILITY PAYMENTS
December 2017 MS 8
3 THE RELEVANCE OF CDI
WHY NOW? For some pension schemes with poorer funding levels, a CDI portfolio may not be able to deliver sufficiently high returns, THE APPEAL OF CDI HAS INCREASED SINCE THE FINANCIAL CRISIS AS THE and therefore other strategies such as a well diversified UNIVERSE OF CDI ASSETS AVAILABLE TO PENSION SCHEMES HAS EXPANDED return-seeking portfolio maybe more appropriate. However, SIGNIFICANTLY. THIS IS BECAUSE BANKS – WHICH NATURALLY LEND ON A if a pension scheme is unable or reluctant to move to a CDI CONTRACTUAL BASIS – HAVE WITHDRAWN THEIR LENDING FROM A RANGE portfolio immediately, it may still be possible to implement OF AREAS WHERE THEY PREVIOUSLY PROVIDED SIGNIFICANT FINANCE, AS A some aspects and gradually move towards a full CDI portfolio RESULT OF THE CHANGING REGULATORY FRAMEWORK. over time. This has in turn created both increased opportunities for Further, if a pension scheme is very mature, and mainly has non-bank private lending by pension schemes and increased pensioner members, this means the liabilities are shorter issuance in public debt markets. Some of these new credit dated (in contrast to pension schemes with many younger opportunities offer potential for a higher return and, members whose liabilities are longer term). As previously alongside the wider range of assets to choose from, they mentioned, CDI assets are only available at maturities which make CDI an increasingly attractive strategy that can be well can cover the short- and medium-dated pension liabilities. diversified across different credit assets. Therefore, the shorter the date of a pension scheme’s Pension schemes are also showing increased interest in the liabilities, the larger the proportion of the cashflows that strategy due to the relatively low governance CDI requires as a can be met by higher-returning CDI assets. As a result, CDI ‘buy and maintain’ portfolio. has most appeal for more mature, better-funded pension schemes, which will more easily be able to generate higher WHO SHOULD USE CDI? overall returns across their full cashflow profile. CDI HAS MOST SMALL VS. LARGE PENSION SCHEMES Initially it was only larger pension schemes that were able to implement CDI using bespoke, segregated portfolios. APPEAL FOR MORE However, most of the key elements of the CDI strategy can now be captured through the use of pooled vehicles designed MATURE, BETTER- to meet demand from CDI clients. Specifically: FUNDED PENSION Long-dated global investment-grade bond funds are now available which are not only managed on a ‘buy and SCHEMES maintain’ basis, but are also managed to target a specific set of benchmark cashflows.
The funding level at which a pension scheme is able to Pooled LDI funds are already well established and can be implement a CDI strategy will be determined by the yield that used to provide a very good overall hedge for interest rate can be secured on a suitably diversified portfolio of credit and inflation exposures. and government bond assets. In particular, a pension scheme Many other long- and short-dated fixed income assets are needs to be sufficiently well funded such that the yield on already available through vehicles which are accessible to these assets will provide enough return for all the liability smaller pension schemes. cashflows to be met. Combining these funds means a CDI solution is now an As a rule of thumb, we estimate that a full CDI strategy available opportunity for smaller as well as larger pension can be implemented once a pension scheme is around 90% schemes. funded, if the liabilities are valued using a gilt discount rate.
MS Cashflow driven investment (CDI) 9
4 CHARACTERISTICS OF CDI
CDI STRATEGIES PROVIDE BOTH A CASHFLOW MATCH, AND A GREATER ASSURANCE OF RETURN THAN TRADITIONAL GROWTH ASSETS
FUNDAMENTALLY, THE MAIN ATTRACTION OF CDI IS THAT IT OFFERS Figure 6: CDI offers a more certain path than a traditional SIGNIFICANTLY MORE CERTAINTY OF ACHIEVING THE TARGET RETURNS ‘growth plus matching’ portfolio REQUIRED TO MEET EACH LIABILITY PAYMENT AS IT FALLS DUE. THIS IS D e r r M c BECAUSE: The ‘shape’ of the return profile from ‘buy and maintain’ CDI assets is fundamentally different from the shape of the return profile of conventional growth assets – essentially er r e
CDI assets have capped upside but more certainty of r e e cee e c me achieving the target outcome.
The assumptions on which a CDI strategy are built are more r e
m e rr er r e robust than those of traditional growth assets because the c me portfolio yield is known at the time of purchase. e r 10 e r 10
THE SHAPE OF THE RETURN PROFILE m cre e
The difference in the ‘shape’ of return is illustrated in the S e re re re e charts in figure 6 below; one of which shows a traditional m r c me
‘growth plus matching’ investment strategy, and one which e c e r b b e ce r shows a CDI approach. The funnels shown in the chart illustrate how much uncertainty both strategies have around their median ‘base Source: Schroders. For illustration only. case’ of meeting the target in year 10. It can be seen that the CDI approach has a much greater certainty of meeting the target. However, while a CDI strategy provides greater certainty (i.e. a narrower range of outcomes), it comes at the cost of less scope for large upside, which you see in the equity portfolio. In addition, CDI could potentially cause greater losses in very unlikely extreme downside scenarios. This is because the traditional ‘growth plus matching’ investment strategy has only 30% invested in ‘risk’ assets (equities), whereas the CDI comparison has 100% in ‘risk’ assets (buy and maintain credit).
December 2017 MS 10
CDI ASSUMPTIONS ‘growth plus matching’ portfolio strategies. The yield on a bond is known at the time of purchase, even if an assumption It is important to note that the return characteristics has to be made for possible defaults, whereas the expected illustrated above only apply if the credit portfolio is held return on a growth asset like equities can only be forecast to maturity using a ‘buy and maintain’ approach whereby with a wide margin for error. the characteristics of the portfolio are preserved over time. This means that if, for example as part of the portfolio As part of the overall CDI approach, it may also be possible maintenance process, one of the 10-year bonds in the to agree actuarial valuation funding plans that are integrated portfolio is sold after one year (when it has nine years with the investment strategy, whereby the liability discount remaining) it would need to be replaced by a nine-year bond rate moves in line with the aggregate yield on the assets. with a similar (or better) yield at that time, otherwise the Adopting this approach can significantly reduce the volatility of target liability match would not be preserved. In addition, the the reported funding position. However, the smoothing of the income and redemption proceeds must be used to meet the reported funding position is not in itself a justification for using original cashflow plan rather than automatically reinvested. the approach. CDI is fundamentally an investment solution, If this is not the case, then there would be further uncertainty with the ability to stabilise the valuation position being an introduced by the fact that the pension scheme would not additional attractive feature rather than an end in itself. know the yield it will be able to achieve when it comes to reinvest the proceeds from the bond. As well as offering more certainty of achieving target returns, it can be argued that CDI strategies are far less reliant on key expected return assumptions when compared with traditional
MS Cashflow driven investment (CDI) 11
5 WHICH ASSETS DOES CDI USE?
THE MAIN CONSTRAINT ON WHICH ASSETS ARE SUITABLE FOR CDI IS THAT THEY NEED TO HAVE CONTRACTUAL CASHFLOWS TO PROVIDE BOTH INCOME AND REDEMPTION OF CAPITAL. IN ADDITION, THEY NEED TO BE AVAILABLE GROUND SENIOR HOUSING IN ‘ROLL-DOWN’ FORMAT, I.E. ABLE TO DISTRIBUTE THE INCOME AND RENTS INFRASTRUCTURE ASSOCIATION REDEMPTION AMOUNTS FROM THE ASSETS AS THEY FALL DUE RATHER THAN DEBT FINANCE BEING CONTINUALLY REINVESTED. The attractiveness of CDI assets depends on their spread and term characteristics, which are shown in figure 7 below. We er r Deb r e b e m r e er e r re ec re c me c S c can broadly divide them into two maturity categories. The c me e e er me cc mm right-hand box covers the longer-dated opportunities (with me e b c e r m c m e e re c me r r c re r ec b c e b er me longer duration), while the left-hand box groups the shorter- me r dated opportunities (with shorter duration). We discuss these categories in more detail below. There have been many other similar types of asset available Figure 7: CDI assets to pension schemes in recent years. However, attractive assets with secure, long-dated inflation-linked income have seen S re significant demand, not only from UK pension schemes but SHORTER-DATED HIGHER YIELDING ASSETS from global pension schemes, wealth funds and - particularly e - large insurance companies seeking to match annuity D rec e e b c e ec r e liabilities. Therefore, whilst these assets can form part of a r ce e ec r e CDI strategy, it could be more challenging to source large e e e eb allocations at attractive net spreads above government bonds. LONGER-DATED OPPORTUNITIES r re In light of this, global long-dated 2 Se r r r c re ce c ce investment grade credit has tended 1 e me r e cre to form the largest allocation of INVESTMENT 0 GRADE the longer-dated assets described 0 2 10 12 1 1 1 CREDIT above as the bedrock asset for most Duration CDI strategies. Investment-grade credit provides significant certainty Source: Schroders. For illustration only. of outcome (i.e. relatively low and e be r c D r e e stable default risk compared with higher-yielding credit strategies). THE LONGER-DATED OPPORTUNITIES Furthermore, sourced globally, the market capacity of this asset class is significantly higher than that of the longer-dated Long-dated assets offering a secure income and capital alternatives discussed above. redemption or amortising (see glossary for definition) stream In the UK, there is a relatively small pool of issuers of of inflation-linked cashflows are the perfect CDI asset, as they maturities over 15 years. Most UK pension schemes seeking make a significant contribution to the overall spread and also to use long-dated investment grade credit as part of a CDI reduce the amount of LDI hedging required. A range of these strategy will thus require a significant allocation to non- assets have emerged in recent years, some examples of which sterling, particularly dollar-denominated, bonds. This creates are shown below. a currency problem for a CDI strategy targeting sterling cashflows. However, the task of hedging cashflows back into sterling can be outsourced to the investment manager, who
December 2017 MS 12
is able to select and manage the required derivative In order to fulfil a true contractual cashflow role, the initial instruments to transform the overseas cashflows into yield on these assets at inception needs to be secured (subject the sterling cashflows required for a UK pension scheme. to a prudent allowance for defaults) without exposure to Therefore, in selecting appropriate ‘buy and maintain’ reinvestment risk, i.e. without the risk that maturing debt investment-grade credit managers, it is important to ensure may need to be reinvested at a lower rate during the life of they have the derivative management skills required to the portfolio. Such security is more commonplace in most of successfully manage the strategy. Furthermore, to optimise the assets above (direct lending assets and real estate debt), the collateral management process necessary for using which are typically bought and held to maturity. derivatives, there may be advantages to combining the role with that of the LDI manager who is undertaking other However, obtaining the required level of comfort is less aspects of the hedging programme. straightforward in assets such as high yield. These are typically actively managed on an ‘evergreen’ open-ended SHORTER-DATED, HIGHER-YIELDING ASSETS basis, with relatively high turnover and reinvestment in benchmark maturities, rather than a focus on rolling down A range of contractual cashflow assets can be considered for the maturity of the portfolio over time. Thus, while traditional this shorter-duration role, including: ‘buy and maintain’ management may not be appropriate for assets such as high yield, some modification of it will be required to ensure that the initial yield secured at inception is realised right up to the maturity of the bonds. ASSET- HIGH BACKED YIELD SECURITIES
eb ec r Deb ec r e ere r e be e me e b er e r e e e ec r e r r c r e e er e e r e r er b rr er be b e cre e e r m e eb re me er ere DIRECT e r e e me r er LENDING b e e c m e e e r r c r e r me c m r e e e cre c r eb
D rec eb ce c m e c INSURANCE- e b c cre REAL LINKED r ESTATE SECURITIES DEBT
e me ec re r ce r r er c e re emb e er c me re r ce e e re m m r r r r m em c
MS Cashflow driven investment (CDI) 13
6 MONITORING AND MANAGEMENT
MEASURING THE SUCCESS OF THE STRATEGY Figure 8: Example CDI reporting IN PREVIOUS SECTIONS, THE CDI SOLUTION WAS DESCRIBED AS BEING VALUE AT VALUE AT UNLIKELY TO EXACTLY MATCH ALL LIABILITY PAYMENTS AS THEY FALL DUE. PREVIOUS CURRENT IDEALLY, THEREFORE, IT IS BEST IF IT CAN BE INTEGRATED WITH AN LDI QUARTER END QUARTER END CHANGE COMPLETION HEDGE. Total assets £80m £85m +£5m CDI surplus/deficit £1.00m £1.02m +£24k The easiest way to explain how this would work is to consider Effective spread over gilts 0.49% p.a. 0.48% p.a. (0.01%) a hypothetical interest-bearing bank current account which accepts any excess cashflows from the assets and delivers cash in the event of shortfalls. This notional current account would also have an overdraft facility, enabling the pension The present value The scheme is The CDI surplus of cash remaining fully funded on improved by £24,000 scheme to borrow to meet cash shortfalls. In reality, this after the final a Gilts + 0.48% due to fewer defaults is not such an alien concept for pension schemes as many pension payment discount rate than expected over already have LDI approaches in place that make use of is made is £1.02m the quarter government bond repo programmes or interest rate swaps.
These are similar to borrowing as they allow the hedges to be Source: Schroders. For illustration only. purchased without the need to put up all the capital normally required at the outset. The pension scheme’s LDI manager will typically be responsible for these arrangements and will have a key role in ensuring the success of the solution. In EVOLUTION OF THE STRATEGY particular, they will have the task of raising additional cash as Given a CDI portfolio will likely match longer-dated liabilities and when required and adjusting the LDI hedge to smooth the with government bonds and use corporate bonds to match cashflow profile and manage reinvestment risk. shorter-dated liabilities, it will naturally evolve into a low-risk Using the current account analogy, the account balance portfolio of government bonds, without the need to rebalance. can be projected forward to calculate the expected amount Further, as this portfolio of government bonds will fully remaining when the final liability cashflow payment is made. match the liabilities, the pension scheme would at this point We are able to do so as we can project the pension scheme’s be fully funded if the liabilities are valued using a government asset and liability cashflows with some accuracy and thereby bond discount rate. This would give the pension scheme the determine any withdrawals from, and deposits to, the current option to negotiate a buy-out with an insurance company, account. Thinking about CDI this way creates a natural depending on pricing at the time. objective for the strategy, which is that the CDI strategy is Such an approach, which should generate greater returns expected to be successful if the current account is positive earlier on (from the CDI portfolio) and have a lower-risk after the final projected pension payment is made. investment strategy at a later stage, is also consistent with This also provides a measure for success that can be the fact that it is normally easier to gauge the strength of a monitored on a regular basis: for example, a successful sponsor’s covenant now than in the future. All other things quarter would be if the projection of the account surplus being equal, this allows greater risks to be taken in the short had improved over the period (as shown in the example in term. By the same token, because pension schemes typically figure 8, right). have a murkier view of the likely strength of the covenant in 10 or 20 years’ time, it would be more prudent for them to be holding a lower-risk portfolio at that time. An example of the evolution of a CDI portfolio which holds government bonds, a ‘buy and maintain’ portfolio of investment-grade credit, a range of higher-yielding short-
December 2017 MS 14
dated credit assets managed in roll-down format (amortising multi-credit), is shown in figure 9 below. 1 DEPARTURES FROM ASSUMPTIONS Looking at this diagram it is very important to highlight that a CDI strategy is not necessarily inconsistent with a longer-term plan to buy out the liabilities with an insurance company, particularly if the strategy is tilted towards holding 2 CHANGES IN FORWARD-LOOKING ASSUMPTIONS higher-yielding credit assets in the earlier years. As the higher-yield assets run off and mature they not only boost the overall funding position but, as shown in the diagram IMPLEMENTATION SLIPPAGE below, result in the remaining assets matching the liabilities 3 with a majority of gilts plus a declining minority allocation to investment grade corporate bonds. With the proportion of pension liabilities increasing inevitably over time, it should become increasingly feasible to use these remaining assets to DEPARTURES FROM ASSUMPTIONS secure a buy-out of the liabilities. Departures from assumptions on the liability side mainly Figure 9: Evolving asset allocation involve differences between demographic assumptions (mortality, date of retirement etc.) and actual experience. On e c m the asset side, differences may occur between assumptions and experience of defaults and recoveries in the credit portfolios. If actual experience is better than expected (e.g. er e cre e if there are fewer defaults than expected) then the pension scheme will generate a surplus. However, if experience is m cre worse than expected the scheme could have a deficit.
r r e b Transfer values are another area that could impact the er cre liabilities as these essentially represent the acceleration of er me budgeted payments. If the basis of calculation is consistent D with the CDI investment policy, which ideally it should be, 201 202 20 20 20 20 then the transfer value should be the value of the bonds that ear theoretically need to be sold to meet the transfer payment. There are, however, some nuances to consider such as making an allowance for transaction costs and any delays between Source: Schroders. For illustration only. making the transfer value offer to the member, making the payment and adjusting the portfolio (by, in theory, selling the matching bonds). MANAGING AND REPORTING We believe pension schemes should also consider the practical issues associated with the inevitable need for the portfolios to be recalibrated from time to time on both the asset and liability side. There are a number of possible discrepancies that could require recalibration of the portfolio. They can be divided into three types.
MS Cashflow driven investment (CDI) 15
In normal circumstances these factors are not particularly significant and, in particular, if transfer values are spread over a lengthy period the impact of delays in adjusting the exposures should broadly average out. Large one-off transfer values do, however, present more significant issues. While implementation of a CDI approach does not preclude pension schemes undertaking such exercises, careful integration of asset sales and exposure adjustments is required. CHANGES IN FORWARD-LOOKING ASSUMPTIONS Changes in the underlying assumptions made to calculate the liabilities tend to have a significant impact because they are forward-looking and extend over several years. The most obvious assumption here is pensioner longevity. The CDI strategy will be built on a set of assumptions determined by the scheme actuary. Subsequent changes in these assumptions, such as increased longevity, will generate a projected shortfall unless additional prudent reserves are built up against such changes from the outset. There is, however, no easy solution to such problems, which ultimately apply to any pension scheme investment strategy and LDI programme (unless explicit longevity hedging is undertaken, for example by way of a longevity swap or insurance contract). However, it can be argued that CDI strategies using contractual cashflow assets to target a small excess return provide more certainty that a reserve will be built up over time than if using traditional growth assets. IMPLEMENTATION SLIPPAGE Finally, any CDI strategy will inevitably incur some implementation gain or shortfall arising from the practical execution of the strategy. This slippage could arise, for example: From the way the inflation hedge is implemented; From any currency hedge used for non-sterling bonds; or From interest rate exposure beyond the term of available bonds. High-quality CDI reporting should identify these items and attribute gains or losses in the projected cashflow match to the component terms so that their significance can be monitored and changes made to the approach if required.
December 2017 MS 16
7 CONCLUSION
CDI INVOLVES ESTABLISHING A PORTFOLIO OF BONDS WHICH, IF HELD TO REDEMPTION, IS PROJECTED TO MEET ALL OF A PENSION SCHEME’S KEY TAKEAWAYS LIABILITY CASHFLOWS AS THEY FALL DUE (AFTER MAKING PRUDENT ALLOWANCE FOR DEFAULTS). 1 CDI strategies provide both a cashflow match, and It is not an alternative to LDI and, indeed, CDI solutions a greater assurance of return than traditional should be integrated with traditional LDI for a complete growth assets solution. Full coverage may also require inflation hedging, 2 The goal of CDI is to secure the return on a portfolio conversion of the currencies of non-sterling bonds and the of bonds at the outset, which is higher than a matching of liabilities beyond the term of available CDI portfolio of government bonds alone and sufficient assets. Furthermore, CDI is not necessarily inconsistent for the assets to meet all liability pension payments with a longer-term plan to buy out the liabilities of a pension scheme with an insurance company. 3 CDI is available to both large and small schemes and will appeal most to those that are mature and A successful CDI strategy offers pension schemes a far better funded higher probability of meeting the liabilities than a typical ‘growth plus matching’ strategy. This certainty is achieved by constructing a portfolio of bonds that, if held to maturity, will fully match the liability cashflows, thereby practically eliminating any reinvestment or redemption risk. In QUESTIONS TO ASK IF YOU ARE exchange, the pension scheme must be ready to forego any CONSIDERING A CDI STRATEGY significant upside, which means CDI is most suitable for mature, well-funded pension schemes that can be confident 1 What investment return does the scheme need to that the limited returns from CDI assets will meet their meet all future liabilities after allowing for any liabilities. sponsor contributions? A CDI solution should be relatively low maintenance, evolving 2 Is buy-out the ultimate objective and if so, what does into a low-risk solution that relies on government bonds to this mean for the overall target return and evolution match liabilities without the need for complex rebalancing of the strategy? triggers. However, there are complexities in the detail of how 3 Which type of credit assets is the scheme LDI and CDI solutions are managed, meaning that monitoring comfortable using, e.g. private credit? and reporting of the strategy is vital to ensure it continues to do what it says on the tin. 4 Can the return target be achieved through a diversified portfolio of these credit assets managed on Recent developments in asset management products mean a ‘roll-down’ basis with limited reinvestment risk? that CDI is now available for schemes of all sizes. Given the benefits of a CDI solution to a mature, well-funded pension 5 What are the potential liquidity requirements of the scheme, it is a topic that should be on the agenda of many scheme, including potential collateral requirements trustee groups, if not now, then at some point in the near and the impact of any transfers out of the scheme? future. 6 Is the strategy consistent with sponsor covenant in terms of amount and type of risk taken e.g. should the solution exclude certain corporate bonds that are correlated with the sponsor’s business? 7 How will the scheme actuary treat the CDI assets and liability valuation?
MS Cashflow driven investment (CDI) 17
8 GLOSSARY
AMORTISING FUND (OR ‘ROLLDOWN FUND’) COLLATERALISATION rate of 5% gives a present value of £100 ÷ (1+5%) = £95.24. The lower the A fund which distributes income and When investing in swaps (and some discount rate, the higher the liabilities. redemption proceeds of the bonds in other LDI assets) a pension scheme is the funds as opposed to automatically entering into an agreement with an DURATION reinvesting into other bonds. investment bank ‘over the counter’ – i.e. entering into an agreement directly with Expressed in years, duration is in this BUY AND MAINTAIN the bank and specific to the particular context the weighted average time contract being arranged. to payment of a pension scheme’s A ‘buy and maintain’ investment cashflows or an asset’s cashflow, once strategy is similar to a traditional ‘buy A swap has zero value at the outset these have been discounted. Duration and hold’ investment strategy, where of the contract. As market conditions can also be a measure of how much a the investor purchases a high-quality change the swap becomes an asset to scheme’s liabilities, or LDI assets (see credit security from a financially strong one counterparty and a liability to the next page), move in relation to changes issuer with the intention of holding it to other, i.e. the swap has a value. The in interest rates or expected inflation. It maturity. The difference with a ‘buy and value of the swap at any point in time is is equivalent to the percentage change maintain’ strategy is that the securities known as the ‘mark-to-market’ value. in value for each 1% change in interest are actively monitored throughout Given that swap contracts are generally rates or expected inflation. A higher their life to ensure they continue to long term in nature, pension schemes duration indicates a greater sensitivity meet the desired characteristics of the rely on the investment bank being in to changes in interest rates or expected target investment portfolio. If a bond’s business at the end of the contract. inflation. credit quality begins to deteriorate To mitigate the risk that the bank and perhaps a default looks likely, the becomes unable to meet its obligations EMPLOYER COVENANT portfolio manager can decide whether under the agreement, swap contracts to keep the bond or replace it with a are ‘collateralised’. This involves The financial strength of the employer higher-quality bond of a similar yield the transfer of assets (i.e. collateral) standing behind the pension scheme. A and maturity. between the two parties with the same weak sponsor is a concern for trustees mark-to-market value as the swap. In as the sponsor may not be able to afford BUY OUT the event of default the party in profit the contributions required to fund the keeps the collateral and retains the pension scheme. Transfer of all of the liability obligations benefit accrued on the contract up to of a pension scheme to an insurance that point. EVERGREEN company in return for the payment of a premium. Evergreen refers to a continuous credit DEFICIT investment that has no maturity date. In CASHFLOW-MATCH The shortfall between a pension practice, this refers to a short-term loan scheme’s assets and the present value of or bond which is continuously renewed Cashflow-matching is a method of its liabilities. so that the principal is remaining hedging cashflows by matching cash outstanding for the long term. outflows (e.g. pension liabilities) with DISCOUNT RATE cash inflows. INFLATION LINKAGE Used by the actuary to place a present CONTRACTUAL CASHFLOWS value (the value today of a sum of money Inflation linkage refers to a payment due or receivable in the future) on a that is dependent on the level of realised Where there is a legal obligation by a DB pension scheme’s liabilities. For inflation. For example, DB pension borrower of debt to make one or more example, if a payment of £100 is due in schemes may have made some promises defined payments at specific dates. one year’s time, then using a discount to members where the payments are
December 2017 MS 18
indexed to inflation, e.g. some members’ LONGEVITY RISK SWAP pension payments may change in line The risk that a pension scheme has A contract between two parties, e.g. a with inflation year on year. to make extra pension payments as a pension scheme and a bank, to exchange INTEREST RATES result of the increasing life expectancy a series of future cashflows according to of its pensioners. Longevity risk could a previously agreed arrangement. LDI The most relevant interest rates for result in payments being made for strategies may use swaps as an efficient pension schemes are those on long- longer than originally either expected way to gain the benefits of interest rates, dated government bonds or long-dated or accounted for, and is something inflation expectations, or gilt returns. interest rate swaps, given the equally to which DB pension schemes are long-term nature of pension scheme particularly exposed. TECHNICAL PROVISIONS liabilities. These interest rates are a The statutory measure used to review key component of the pension scheme’s MATURITY the pension scheme’s liabilities every discount rate (see ‘discount rate’ on Maturity is the date on which the life of three years as part of the triennial previous page). The nominal interest a transaction or financial instrument actuarial valuation. It is also usually rate represents the interest rate on ends, after which it must either be used to calculate the pension scheme’s fixed-interest gilts and can be used to renewed or it will cease to exist. For funding level (e.g. to work out what, if value pension liabilities that are fixed in example, a bond which has been issued any, deficit contributions are required nature. The real interest rate reflects the for 10 years is said to have a maturity of from the corporate sponsor). interest rate earned on inflation-linked 10 years. investments over and above expected TRANSFER VALUE inflation. The real interest rate can be REINVESTMENT RISK used to value inflation-linked liabilities. A transfer value is the amount of money This refers to the risk that the principal your pension scheme would pay to LIABILITY-DRIVEN INVESTMENT (LDI) from maturing investments will have another pension arrangement in lieu to be reinvested at a lower rate than the of the benefits you have built up in the The ultimate objective of pension original investment. scheme, if you decided to transfer your scheme investing is to ensure that there pension from that scheme. are sufficient funds to pay the liabilities. REPURCHASE AGREEMENTS (‘REPO’) LDI puts this objective at the heart of a YIELD DIFFERENTIAL (OR ‘SPREAD’) pension scheme’s investment strategy. A contract with a counterparty (usually A key aim of LDI is to manage funding- a bank) whereby a gilt is sold at current Otherwise known as ‘spread’, this refers level risk (i.e. the variability of the market value under an agreement to buy to the difference in yield between two pension scheme’s assets compared to its back (repurchase) the same gilt from the securities. This term is often used to liabilities). This usually means using a counterparty for a fixed agreed price describe the increase in yield between a range of assets, such as swaps and gilts, at an agreed future date. The seller of credit asset and a government bond. For to construct an investment strategy the gilt thus retains economic exposure example, if a corporate bond has a yield that closely matches the behaviour of to the gilt while releasing cash for of 3% while a government bond has a the pension liabilities. These assets investment elsewhere. yield of 2%, this would result in a yield are often referred to as ‘LDI assets’ or differential of 1%. In this example, this ‘matching assets’. could also be referred to as the ‘credit spread’.
MS Cashflow driven investment (CDI) 19
DISCLAIMER The Pensions and Lifetime Savings Association 2017 © All rights reserved. You must not reproduce, keep, or pass on any part of this publication in any form without permission from the publisher. You must not lend, resell, hire out, or otherwise give this guide to anyone in any format other than the one it is published in, without getting the publisher’s permission and without setting the same conditions for your buyers. Material provided in this publication is meant as general information on matters of interest. This publication is not meant to give accounting, financial, consulting, investment, legal, or any other professional advice. You should not take action based on this guide and you should speak to a professional adviser if you need such information or advice. The publisher (The Pensions and Lifetime Savings Association) or sponsoring companies cannot accept responsibility for any errors in this publication, or accept responsibility for any losses suffered by anyone who acts or fails to act as a result of any information given in this publication. ISBN: 978-1-907612-52-7
December 2017 MS Pensions and Lifetime Savings Association Cheapside House, 138 Cheapside, London EC2V 6AE
T: 020 7601 1700 E: [email protected]
www.plsa.co.uk
December 2017
This guide is for information only and is not advice about investment or legal matters and must not be relied upon to make any financial or legal decisions.