Data crunch: Defined benefit trustees are in a bind on cash flows, with low or even negative yields persisting in traditional fixed income just as their schemes’ liabilities begin to mature and cash injections dry up. Asset managers are responding by offering new solutions to help access alternative, secure income-generating assets.
Alternative assets have traditionally been used by institutional investors for diversification or return enhancement, in building investment portfolios that can offer strong, smooth returns. However, as schemes are maturing and turning cash flow negative, their needs are changing.
DB schemes are now increasingly looking at real assets and alternative credit as a source of reliable income that can help them meet their pension payments.
In an environment where yields on traditional fixed income assets are insufficient to meet many schemes’ cash flow needs, secure income assets are likely to offer an attractive alternative
The popularity of these asset classes is apparent in recent flow data. Over the past two years, third-party asset managers have received £26bn in allocations to property, £16bn in private debt allocations, and £12bn in infrastructure allocations from institutional investors in the UK.
Schemes must stave off insurer competition
Although these assets can offer attractive returns, there are challenges for DB schemes. One key issue is that these assets are also favoured by other institutional investors such as insurers, for whom they are key components for capital-efficient portfolios under the Solvency II regulatory regime.
This competition from assets can crowd out DB schemes and result in less attractive returns.
A second challenge is that many of these investments are illiquid, and schemes therefore run the risk of not being able to find a willing buyer in the case of having to sell assets to meet short-term liquidity needs. This is a key consideration for schemes that are experiencing substantial member transfer activity, and for plans needing access to liquidity when preparing for a buyout transaction.
The complexity of these asset classes also imposes a higher governance burden on schemes. Smaller plans in particular face challenges in meeting minimum investment sizes for some alternatives allocations, and in ensuring that the assets can be successfully integrated into a diversified investment portfolio.
Managers developing solutions aid scheme access
Managers are building alternatives platforms and funds to help provide flexible access for plans, as a means of designing portfolios structured around schemes’ cash flow needs.
For a large, sophisticated DB scheme, an alternatives platform may offer access to a range of implementation methods, such as mutual funds, mandates or co-investment opportunities. For smaller schemes a bespoke solution may not be achievable, but pooled funds can provide access to a diversified set of alternatives assets that generate secure income.
The benefits of these solutions extend to the range of asset classes that can be accessed. For schemes looking to boost yields or cover liabilities over the short to medium term, structured finance or private loans strategies may be appropriate. In contrast, for plans looking to build a long-term cash flow solution that minimises reinvestment risk, long-dated assets such as long-lease property or infrastructure debt may work better.
In an environment where yields on traditional fixed income assets are insufficient to meet many schemes’ cash flow needs, secure income assets are likely to offer an attractive alternative. Schemes now have an opportunity to access these assets by demanding high-quality solutions from their asset managers.
Jonathan Libre is a principal in the Emea Insights team at Broadridge Financial Solutions
