What about cash flow: Balancing LDI and growth assets

Giles Payne: One thing which we have not mentioned yet is being cash flow aware within your liability-driven investment strategy. A lot of schemes are now getting to the stage where they are cash flow negative, they need to generate cash.

If you have a substantial portion of your assets tied up in non-cash-generating assets, that can cause problems when you are looking at generating your excess return.

So I am starting to see an acknowledgement of how real assets fit into cash flow generation and also some of the hedging effects they have. Even though they are not explicit and they do not naturally fit into models, you know perfectly well that if you have cash flow being thrown off by an asset for 20 years, it is going to be very useful in terms of immunising your risk.

Simeon Willis: But also I suspect the negative cash flow point is being used as an excuse for people not to enter into these arrangements, because often they have trading costs that can be illiquid.

I think that is an excuse too far, because for most schemes I look at and the liquidity requirements they have compared with the liquidity available in the portfolio, there is massive headroom for them to absorb more illiquidity.

Payne: A lot of people do not necessarily want to be selling assets all the time, they would rather be generating the cash and creating the income against which to pay the benefits.

I have seen two or three solutions produced where there are quite reasonable cash flow requirements. If we are not careful, those requirements can disrupt the hedging available within the portfolio because the portfolios, rather than being fully leveraged, tend to be quite real, for example gilts-based. If you are trying to pick income out of those and maintain the hedge perfectly, it can be complicated.

Rakesh Girdharlal: I think it is becoming increasingly challenging to separate an LDI portfolio from a return-seeking portfolio, and having a more integrated approach is far more efficient than splitting them.

We found a lot of pension schemes are focusing on collateral, and how do you actually collateralise a lot of your derivatives? The market is moving towards a cash collateralisation.

So, yes, the liquidity aspect is important, but if you split out your assets into separate categories, you find you are holding buffers of cash all along the way and you have this inefficient allocation of cash. Bringing all of your assets together just makes it a lot more powerful.

Huw Evans: I do observe that often the amount of collateral you need versus the amount of growth assets you need to support your valuation discount rate is what defines your hedge ratio. You sort of reverse-engineer how much hedging you can afford, and that always struck me as suboptimal.

Benoît Jacquemont: I think the decision is about balancing the leverage on your LDI portfolio. Yes, leverage is important, but how much should you take? Yields are extremely low; we do not see them rising any time soon. I think we should probably be more reasonable on the leverage, in some cases, and balance this by taking more illiquidity premium to boost the expected return on the gross asset as well. For me that is the key decision at the moment.

Evans: I think it is a little odd just how liquid the pension funds are. They do not actually need that and we ought to be able to harvest illiquidity. But when you look for a way to do that, the returns do not make it worthwhile. You can get pretty good returns and still have liquidity, which is obviously a lot safer from your point of view, because you can change direction very quickly.

I am mostly thinking about infrastructure assets, or property. The levels of investment in property are actually pretty low. The challenge is that increasing numbers of schemes are becoming cash flow negative and so generating cash flows from your assets is becoming more and more pressing. So we may see a shift, but if you look at how UK pension funds are invested they have an extraordinary amount of liquidity relative to their need.

Barbara Saunders: Just to talk about the leverage point, we are already starting to see pressure on leverage levels in LDI in traditional pooled funds from the new Emir requirements, from the fact that you need initial margin now, as well as variation margin, to post as collateral.

It affects both pooled funds and bespoke arrangements. But with pooled funds, in particular, the banks are looking at a pooled vehicle rather than directly at the pension scheme, so they are seeing that they are engaging with a leveraged entity and imposing more stringent capital requirements on those, which is going to reduce leverage.

So we need to be careful we do not try and reduce leverage from all angles when actually regulation is requiring it and it still makes it a very viable investment. But we need to make sure we are covering the amount of risk we need to without reducing the leverage too much.