Which investments can cash flow negative schemes turn to?

Many funds are facing the prospect of payments to retirees exceeding contribution income for the first time.

When a pension fund has to pay out more than it receives, it may be forced to sell its return-seeking assets at an untimely moment.

Growth assets such as private equity and real assets including infrastructure investments have the potential for long-term attractive returns, but they are illiquid, and so it may not be possible to sell them to pay pensions when required.

Listed equities likewise may suffer from mark-to-market volatility and may not be realisable at a fair price when disposal is necessary.

Contractual cash flows can provide control and greater certainty over the timing of returns to investors

In other words, being a forced seller at the wrong time could impair a pension fund’s ability to meet future obligations, and as many investors expect uncertainty and volatility to be prevalent through the year, this could be an increasing concern for maturing pension funds.

At the same time, credit investments, which have traditionally been used to diversify growth assets and provide steady income, face serious headwinds.

Investment grade corporate bonds offer low yields, while obtaining greater income through high-yield debt risks potential losses and big mark-to-market moves if there is a change in market sentiment or turn in the default cycle.

In combination, these trends present maturing DB pension schemes with a serious challenge. This is leading many to consider alternative asset classes and approaches to portfolio construction.

Opportunities in private debt

In the face of these challenges, one asset class being considered by many pension funds is secured finance, which essentially comprises investments via collateral-backed securities and loans.

Examples include providing finance to companies to write mortgages; real estate lending, where finance is provided to companies to acquire assets like offices; and investments in asset-backed securities.

Some investors are attracted to such assets because they can offer excess yield, relative to equivalent investment-grade corporate bonds, due in part to the largely under-researched nature of the investments and also the reduced involvement of banks in these areas.

A premium is available from the asset class that is associated with the complexity and reduced liquidity of the underlying assets.

The characteristics of secured finance also mean the asset class is well suited to helping pension funds manage the impact of negative net cash flows. Asset-backed securities and loans confer contractual obligations on the borrower to make payments.

Contractual cash flows can provide control and greater certainty over the timing of returns to investors. The predictable nature of the return stream can also help long-term investors avoid being forced to sell down return-seeking assets to meet short-term cash flow needs.

For example, a pension fund might hold a ‘drawdown pot’ of highly liquid, short-dated assets less prone to mark-to-market risks, such as money market investments, cash and short-dated bonds. The pension fund can use this drawdown pot to pay pensions.

To enable the drawdown pot to continue performing its role over the longer term, a portion of assets can be held in medium-term assets with contractual cash flows, such as secured finance assets, which will naturally generate cash to top up the drawdown pot as the assets mature, without needing to sell other assets.

This process can retain the upside generated by long-term growth assets, avoiding needing to sell them at inopportune times, while addressing the potential adverse impact of negative cash flows.

As pension funds face increasing uncertainty, coupled with the prospect of net negative cash flows, alternative approaches to portfolio construction and considering new asset classes can offer opportunities to manage such challenges.

Steve Aukett is head of solution design in Insight Investment's client solutions group