DB Pensions – Does cashflow impact your asset allocation?

February 11, 2016 Categories: Implementation, Investment Strategy

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Does cashflow affect the way you should invest? Absolutely; in this blog I will explain two features that arise when setting investment strategy.

The setting of a pension fund’s overall asset allocation is influenced by many differing factors. Underfunded, mature funds not only have a shortened period to address any deficit but also need to be aware of the impact of having net cash outflows (negative cashflows). Cash outflows occur when the pension fund pays out more in benefits payments than it receives in contributions.

For an underfunded plan, having net cash outflows increase both the required returns to regain full funding & magnifies the downside risk. So mature funds with net cash outflows face a triple whammy with not only shorter investment horizons but also higher required returns & larger downside risks.

What’s the problem?

In short, increased required return and higher downside risk.

Consider an 80% funded plan that has a 10% net cash outflow. Of that 10% paid out, only 8% exists in the fund so investment returns must generate an extra 2%. Actually, there is only 80% of assets to cover this 2% so the funds must generate 2%/80% = 2.5% extra return. The following year a similar argument would apply with a similar amount of extra return required, as the fund continues to experience equivalent cash outflows. Fortunately, most plans do not yet have negative 10% cashflows – but this illustrates how significant an issue this could be.

Not only does a higher cash outflow require a higher return, it also puts more stress on the assets in the event of a market downturn. Schemes that have high cash outflow do not have the chance of recouping market losses after a few bad years of investment returns, because they have already sold their assets when performance was poor to pay the pension payroll. The Communique paper found here explains in more detail the impact cashflow drag has on required returns and downside risk.

How should pension plans respond? Dynamic Asset Allocation and Dynamic Derisking

Firstly, plans should be aware of the impact of cash outflows on their investment strategy and required returns.

Multi-asset investment strategies that reduce portfolio volatility can be very beneficial. For mature pension plans mitigating downside risk is important because they have a limited time horizon to address the deficit in the scheme.

Also important is the need to reduce investment risk over time due to the larger downside risks as cash outflows grow. Derisking strategies are very attractive for both sponsors and trustees when the plan is mature and the pace of benefit payments is high. Trustees and sponsors who use investment risk as part of their funding policy should fully explore dynamic derisking strategies as part of the overall risk budgeting process. As pension plans mature it can be very beneficial for the asset allocation to be programmed to systematically take investment risk off the table.

Crevan Begley, Client Strategy & Research, EMEA

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