On the go: With two-thirds of FTSE 350 pension schemes in negative cash flow, fears are mounting that there may not be enough high-quality assets to go around.
As pension funds switch their emphasis to income-yielding assets, there is just not enough UK credit to satisfy their demands, and not even enough government debt, according to one asset manager.
Sorca Kelly-Scholte, Emea head of pensions solutions and advisory at JPMorgan Asset Management, says: “The sterling corporate market is about £400bn in size, but we have £2tn of UK defined benefit liabilities.
“If UK pension funds, in general, were to match 5 per cent of their liabilities using sterling corporate credit, they could swamp the market pretty quickly. If the UK pension schemes are going to move en masse in this direction, they are very quickly going to run into sand when trying to implement the change.”
As we see a wider embracing of these strategies, I think we will begin to hear of more capacity issues
Sorca Kelly-Scholte, JP Morgan Asset Management
Cash flow-driven investing has spiked competition for long-dated sources of income, notably in the UK high-quality, investment-grade credit market, where pensions are already up against insurance companies trying to snap up that debt.
Ms Kelly-Scholte ran a scenario analysis to try to judge the capacity limitations of UK corporate credit. For one large, mature UK DB plan, assuming it was to seek to hedge 25 per cent of its total liabilities, a total of £11bn would need to be allocated to suitably long maturity holdings.
That would theoretically lead the scheme to owning a quarter or more of the entire 30-year maturity and above segment of the UK corporate credit market, if it could even find sufficient bonds to buy.
Equally concerning, Ms Kelly-Scholte found that the plan would have to accept lower credit quality, increasing its default risk.
“As we see a wider embracing of these strategies, I think we will begin to hear of more capacity issues,” she warns.
Global market offers solution
Her solution is to turn to the US credit market, which is much deeper and more diverse. The broader securities market could provide additional capacity over constrained UK markets.
Clearly, there is a currency challenge. Schemes will need to hedge currency and duration risk, but Ms Kelly-Scholte says: “When we allow for the costs of doing that, it tends to equalise the yield. So you get similar yield and stronger diversification.”
She advises trustees to think about the challenges explicitly: “Look at cash flow challenges strategically and build up more income-generating assets – real assets [such as] property to generate durable long-term cash flow.”
