Why is cashflow driven investing the latest craze?

cashflow driven investing

In the second part of our series showcasing the best of Russell Investments’ Annual Investment Summit, David Rae dispels some myths about cashflow driven investing (CDI). He urges investors to view CDI as a risk management framework, not a product.


 

“The Latest Craze”

 

My friends are at it, they say it’s cool and everybody’s doing it
–The Latest Craze, Showaddywaddy, 1975.

 

Without doubt, the most talked about issue of 2017 in the pensions investment landscape has been the issue of cashflow negativity and the use of cashflow driven investing (CDI). You don’t have to look far to find a new product purporting to solve this issue.

At our recent Annual Investment Summit, I explored this issue, dispelled some of the myths and urged investors to view cashflow driven investing as a risk management framework, not a product.

 

Is cashflow negativity really an issue?

 

The short answer is that for a few schemes it is a critical issue today, but for most there is still a bit of time before cashflows become the driver of investment strategy.

As schemes have matured and closed to new members, the cash outflow is beginning to become a dominant feature in setting investment strategy. In the UK only 15% of defined benefit (DB) pension schemes are currently open and only 12% of members are active.

Recent studies have highlighted the transition to a cashflow negative status for UK pension funds. Let’s be honest, this shouldn’t come as a surprise and a modest level of cashflow negativity is not a major issue. Given the yields available, most schemes can support a 2% or 3% excess of benefit payments over contributions with their current investment strategy. The minority of schemes with cashflow negativity greater than 5% may need an urgent review but generally, there is no need to do anything radical today.

 

Too good to be true?

 

It feels at times that CDI is almost being presented as a panacea. If someone offers you a CDI fund, they probably haven’t put much thought into your cashflow driven investing needs. There is a danger, as has happened with LDI (liability driven investing), that CDI becomes commoditised into a bunch of products rather than respecting it as a risk management framework.

 

A different way of looking at risk

 

From my perspective, CDI is very much about a different way of looking at risk. Over the last decade or more, schemes have designed their investment portfolios to manage funding level risk. The use of derivatives to hedge liability valuation risks is a necessary pillar of these strategies. As pension schemes become better funded and closer to the “end game”, they naturally change their risk management metrics to focus on the cashflows. The instruments and techniques employed will change accordingly and this evolution of investment strategy is the right way forward.

 

Is CDI the right thing for your scheme?

 

A question I’m often asked by Trustees is whether CDI is the right approach for their scheme today. The answer I typically give will focus on the financial health of the scheme, the complexity of the liability profile, and the balance of objectives between buy-out and self-sufficiency.

Well-funded schemes targeting self-sufficiency can probably adopt a CDI risk management framework today. For many others, the LDI journey may end at CDI in the future but there is no need to rush today.

While CDI is the latest craze and provides a very valuable means for examining risk, whether it is right is a scheme specific question. It is not simply because you have negative cashflows or even “they say it’s cool and everybody’s doing it”.

 

Watch this space

 

Between now and the new year, we will be writing a series of blogs showcasing the best of the Annual Investment Summit. Hear from David VickersWill PearceAdam SmearsJames MitchellVan Luu and many more.

Visit the Annual Investment Summit webpage for more information about the event including the presentations, write-up and speakers.

To register your interest in the 2019 Annual Investment Summit, please email events@russellinvestments.com.

 


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Bulk annuities – 2017 NOT the year to buy-out?


David Rae – Head of Client Strategy & Research

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