From the blog: If there is one thing UK defined benefit schemes are not paying enough attention to, it’s cash flow. As many funds face the prospect of payments to retirees exceeding contribution income that is creating significant implications for investment strategies.
Negative cash flow status can be particularly painful for underfunded schemes.
As many funds face the prospect of payments to retirees exceeding contribution income – an inevitable consequence of schemes maturing – that is creating significant implications for investment strategies.
Negative cash flow status can be particularly painful for underfunded schemes, which is the unfortunate reality for the vast majority of them.
A shift towards buy-and-maintain credit would further reduce liquidity in the marketplace
Being in negative cash flow inherently raises the level of return required to achieve funding targets, and if returns are insufficient, funded status will drop further, creating a difficult cycle. The limitations of a low return environment – which effectively puts a damper on returns that might help to shore up funded status – compounds these challenges.
Negative cash flow also puts pension schemes at risk of becoming forced sellers of assets in order to service cash flows. If this occurs after periods of market drawdown, a loss is locked in.
On top of this, a scheme in negative cash flow will be at increased risk of liquidity squeezes and will need to address the operational challenge of regular divestment of assets.
Which asset classes will DB schemes look to?
It is likely that increasingly negative cash flows will lead to demand from schemes for asset classes that offer fixed or contractual cash flows, whether bonds or real estate or infrastructure or private credit. These can provide a degree of control and greater certainty over the timing of returns to investors, allowing them to better align payouts with obligations.
DB schemes are expected to switch to buy-and-maintain style credit portfolios, structured to manage short-term liquidity requirements as well as duration risk.
Are real assets the answer for cash flow negative schemes?
As more schemes think about how to invest for cash flow, real assets appear well placed to fill the space. But how are concerns over liquidity addressed, and what are the latest developments in the infrastructure market? Five experts share their views.
High-yielding, stable cash flow assets, such as core real estate and infrastructure, are increasingly attractive for DB schemes. The alternative credit markets are also likely to continue to be a key area of interest for schemes seeking stable yield.
But what does this mean for schemes' demand for bonds? The expected sustained demand for bonds is already well established – matching assets and liabilities as an approach to derisking pension plans is a long-standing industry megatrend.
However, a shift towards buy-and-maintain credit would further reduce liquidity in the marketplace. Once schemes become fully funded and matched, demand for bonds will begin to drop off – the principal repayments will be applied to service cash flow and will not be available for reinvestment. Really, a reasonable proportion of schemes could reach this status in the next 10 to 15 years.
Ultimately, the landscape for UK DB pensions is changing, and being cash flow negative is the inevitable fate of all schemes. The challenge at this point for scheme managers is around careful planning and risk management to make disinvestments as efficient as possible as they pivot towards a more cash-driven investment approach.
Sorca Kelly-Scholte is EMEA head of pensions solutions at JPMorgan Asset Management
