In a recent article, we warned that the generally underfunded and increasingly cashflow-negative UK Defined Benefit (DB) pension sector could see its funding status challenged, especially in the present late-cycle environment. We argued that a Cashflow Driven Investment (CDI) approach could be a solution, to help meet liability payouts with a high degree of certainty.
Let’s now roll up our sleeves and explore how CDI could be brought into action. Should schemes solely focus on Sterling denominated assets? Should portfolios be managed actively?
UK or Global?
In an ideal world, a CDI portfolio would be void of currency risk and foreign interest rate risk. However, the relatively limited size of the UK Investment Grade (IG) corporate bond market would make it rather challenging to construct a purely domestic CDI portfolio because:
- A smaller opportunity set would likely lead to a less diversified portfolio, which in turn could increase its potential default exposure under certain scenarios.
- A lower yield (relative to the higher yield available in other countries) would translate into a lesser coverage of future liability cash flows for the same capital commitment.
- More limited liquidity may translate into higher transaction costs and therefore reduce the amount of liability cash flows covered for a given capital commitment. It would also make future adjustments to the CDI portfolio more challenging.
- A significant take up of CDI strategies within the UK DB community could be disruptive, given the modest size of the UK Investment Grade (IG) corporate bond market (c. GBP 500 bn) relative to the size of the DB pension industry (c. GBP 2trn).
We therefore believe a global scope provides a more desirable foundation to build a CDI portfolio; it may also help plan sponsors achieve better asset-liability outcomes (provided that the associated currency and foreign interest rate risks are properly managed).
A passive buy and hold approach in the context of CDI may at first glance sound appealing due to its implementation simplicity. However, and as we discussed in our previous article, cashflow negativity increases a scheme’s vulnerability to portfolio impairments, which in the case of CDI would be due to permanent default losses. Such losses could be exacerbated with a passive buy and hold investment strategy. However, this risk could be mitigated by default-adjusting the cashflows of a CDI portfolio at inception (e.g. using Moody’s cumulative losses by rating). To assess the efficiency of a passive CDI approach, we back-tested the performance of a simple hypothetical default-adjusted, buy-and-hold investment grade (IG) CDI portfolio strategy initiated monthly between January 2004 and December 2008.
Our back-test methodology was as follows: at the beginning of each month over the 2004 to 2008 period, we solve for the budget-minimising1 IG corporate bond portfolio2 (within the ICE Merrill Lynch USD Corporate bond universe3), which matches on a default-adjusted basis4 a specified 12-year annual liability stream (in USD). The portfolio is held over the duration of the 12-year liability stream, during which time liability cashflows are met primarily with portfolio cashflows. The portfolio is self-funded - i.e., a cashflow shortfall in any given year is funded by selling assets from the remaining portfolio on a pro-rata basis. Equally, any surplus is re-invested.
At the end of the 12-year period, we measure the difference between the realised CDI cashflows and the expected (or liability) cashflows as an adjustment to the initial portfolio yield (YTM in the formula below). Then we solve for an annualised excess loss rate (el):
Where are the portfolio expected default-adjusted cashflow in year t.
Intuitively, when the CDI portfolio delivers less (more) cashflows than initially expected, this results in a positive (negative) annual excess loss rate (“el”). The table below shows a summary of our test results:
We found that over the observation period (60 portfolios initiated between January 2004 and December 2008), on average portfolios experience higher losses than were expected at the outset, equivalent to 18 basis points (bps) per annum, with a median of 16bps. In over 25% of the samples, annualized losses exceeded ~27bps.
While an average annual excess loss of ~20bps may not seem significant, the potential impact this would have had on a scheme over this period is surprisingly large. The chart above shows the impact on the expected path to full funding of the same cashflow negative scheme that we illustrated in our previous article (4-5% in the first 10 years).
By applying the average excess losses estimated in the sample, we found the potential effect on the expected time to full funding of a cashflow negative scheme results in an additional 4 years, shifting the number of years required to achieve full funding from 13 (“Baseline”) to 17 (“Passive CDI”). This is comparable to the impact from a 25% equity drawdown.
We now contrast these results with a hypothetical actively managed CDI portfolio, with an assumed symmetrical annual outperformance of 20bps versus the “Baseline”. In this case, we found that the expected time to full funding was accelerated by 3 years, from 13 to 10. In other words, the difference in the expected time to full funding between a passive CDI portfolio and an active portfolio with a modest alpha target (20bps) can be highly significant: as much as 7 years (17 versus 10) in our example.
Given the findings from our analysis above, we believe a globally-focused and actively managed IG corporate portfolio and a careful portfolio construction can help UK DB schemes better plan and meet future liabilities. There is, however, one further issue to bear in mind: foreign currency management – but we will leave this for the next and the final article of our series.
To see whether CDI is right for you and how to implement it, please visit pimco.co.uk/institutional-investment-themes
Or speak directly to the team