Cashflow driven investing (CDI) is an investment approach that helps defined benefit pension schemes pay their ongoing benefits and meet their long-term funding objectives.
To generate predictable cashflows, CDI strategies typically focus on high-quality fixed interest investments, such as investment-grade corporate bonds, arranged in a way that minimises the risk of having to disinvest assets at potentially inopportune times, especially in volatile markets.
These types of assets can provide stable, predictable contractual income that is paid in line with the expected cashflow requirements of the pension scheme.
The erosion problem caused by volatile returns
As defined benefit pension schemes continue to mature (and in many cases become increasingly cashflow negative) the dangers of having to sell assets at a depressed level, to meet benefit payments, increases.
For example, a mature defined benefit pension scheme might require annual disinvestments of around 7% of its assets to meet benefit payments. Over three years, this would mean about 20% of total scheme assets are sold to pay benefits.
For many schemes, this income yield level required will be considerably higher now than it was a year or more ago, due to the higher interest rate environment which has reduced asset values.
Financial market history tells us that market crashes (periods of poor investment returns) are often followed by market corrections (periods of high investment returns) and vice versa.
Over time, the psychological and emotional factors that impact investment returns can be expected to cancel out, with long run investment returns ultimately being driven by more tangible, fundamental factors.
However, cashflow negative investors don’t have the luxury of long run averages.
In volatile markets, chipping away a fifth or more of the portfolio’s value during a downswing can seriously undermine the ability of the remaining assets to deliver the returns required to fulfill a scheme’s funding plans.
The CDI solution
One way to manage the significant impact a market downturn could have is to ensure the investment strategy is able to generate a sufficient level of income each year. This income could be used to meet the expected amount to pay benefits without having to sell assets.
Income can be provided by coupon and redemption payments from fixed interest holdings, the maturity of which can be structured to match the expected benefit outgo over the short term, for example, the next five years.
For every year that investment returns are in line with expectations or better (i.e., a scheme’s funding position is at least on track), a tranche of the riskier assets such as equities can be sold, to fund the purchases of additional fixed income assets within the CDI strategy.
This could then maintain the expected cashflow matched position over the desired period (five years in this example), which would otherwise roll down every year. During a year when investment returns are poor, riskier assets could be retained rather than being sold, and the matched cashflow position would be allowed to roll down temporarily.
Building in a sufficient period of cashflow coverage allows a scheme to be more patient in terms of the timing of any subsequent asset rebalancing and further purchases of CDI assets.
For a scheme that is already well-funded, there may be little or no need to continue to hold more volatile growth assets and a substantial proportion of the investments could be invested in a CDI strategy.
For these schemes, CDI reduces the variability of the future realised return. Market sentiment would no longer impact future realised returns, only the actual pattern of returns achieved from the investments held.
Depending on a scheme’s funding position and circumstances, CDI will have differing levels of attractiveness.
Given many defined benefit pension schemes are closed to new entrants and are becoming significantly mature, the application of the approach is likely to remain attractive and become even more widespread.
Crevan Begley is the investment director of Broadstone, which advises on pensions, investments and employee benefits.
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