Shajahan Alam from Axa Investment Managers explains why what's good news for your funding level often means you have to manage cash flow more carefully.
Action points
Hold more assets that provide contractual cash flows
Don’t tie up cash if you don’t have to – for example, equity exposure could be achieved using derivatives, thus freeing up cash
Focus more on managing cash requirements – for example, avoid forced asset sales by using repurchase agreements to manage short-term needs
While persistently low nominal and real interest rates continue to frustrate this goal, all is not bleak – some developments are working to improve solvency.
Some of these are outside of trustee or sponsor control; a good run of equity returns, and recent findings by consultancy PwC that the pace of improvements in longevity are turning out to be lower than previously expected, could mean schemes will become better funded in the near future.
When a scheme’s deficit falls, deficit repair contributions being made are also likely to fall. This means a scheme is more reliant on its assets to meet ongoing pension payments
Active efforts are also being made to improve solvency. Liability management exercises typically improve a scheme’s funding level, but also change a scheme’s cash flow requirements.
There has also been a surge in members transferring out of their scheme, attracted by the high transfer values on offer and to take advantage of pension freedoms.
Clearly, anything that improves a pension scheme’s solvency is to be celebrated, but when a scheme’s deficit falls, deficit repair contributions are also likely to fall. This means a scheme is more reliant on its assets to meet ongoing pension payments.
While it is true that schemes that are no longer open will naturally approach a cash flow negative state at some point, these developments potentially accelerate that journey. Schemes may need to start preparing sooner than they think.
Schemes need to manage liquidity
Updated mortality projections released in March 2017 by the Continuous Mortality Investigation show the rate at which longevity has been improving recently has been lower than in previous years.
This means the scheme actuary could assume fewer pension payments will be made from the scheme. If so, the value placed on the scheme’s liabilities would be lower. Estimates vary; PwC says liabilities could fall by as much as 15 per cent.
It remains to be seen whether actuaries will revise their valuation assumptions. One argument asserts it may not be prudent to assume the slowdown applies to members of defined benefit schemes, as they have different characteristics to the general population.
In any case, the potential impact is a better funded scheme. This means the deficit – and associated repair contributions – could fall dramatically, while immediate pension payments do not. The scheme can quickly move to being in a cash flow negative state.
Other factors that impact your cash flow
The MSCI World Price Index recently increased by more than 30 per cent since the lows of February 2016, benefiting a typical scheme and potentially leading to lower deficit contributions.
Again, lower deficit contributions mean a greater reliance on assets to meet benefit payments.
Incidentally, if lower deficit contributions are to be agreed then it may make sense to lock in some of the equity returns upon which these are based. This could be through selling equities or protecting the scheme’s equity portfolio using derivatives.
Liability-management exercises are designed to make schemes more affordable. So, changing the benefit structure, for example from final salary to career average, would reduce the ongoing contributions to a scheme. A more dramatic change is to close the scheme to future accrual, in which case ongoing contributions stop.
Pension increase exchanges – where members are given the option to exchange inflation-linked increases for flat pensions – typically result in improved solvency.
Which investments can cash flow negative schemes turn to?
Defined benefit pension funds will face significant pressures in 2017, including market uncertainty and potentially increased volatility. An additional issue many funds will have to grapple with is how to manage their investments as the scheme matures.
So do exercises that result in scheme members taking transfer values. Enhanced transfer value exercises, and the large increase in transfers from schemes following the introduction of defined contribution pension freedoms, will have helped to boost scheme solvency – albeit requiring significant cash outflows in the short term.
These developments indicate that contributions could be falling while cash flow requirements in the near term could actually increase.
Many schemes may find themselves in a cash flow negative state sooner than they think. And while solvency may still be elusive, the need to ensure the assets deliver enough cash and at the right time will become key to good pension scheme management.
Shajahan Alam is head of solutions research, UK LDI at Axa Investment Management
