Despite a strong tailwind from equity markets,

Transcription

1 Deutsche Asset Management ASSET ALLOCATION February 2018 AN INTRODUCTION TO CASH- FLOW-DRIVEN INVESTING (CDI) Many pension schemes are underfunded and do not generate sufficient cashflows. It is time for sponsors to look beyond traditional approaches. CDI is one potential solution. SUMMARY Despite a strong tailwind from equity markets, many UK defined benefit pension schemes have high and volatile levels of underfunding. At the same time cashflow management is a major consideration as more than half of schemes are cashflow negative1. Both issues are growing in urgency. Defined benefit schemes have traditionally used a two part investment strategy. Growth assets play a longterm deficit reduction role and are weighted towards equities. Liability-matching assets are typically gilts combined with derivative overlays that help to hedge interest rate and inflation risks an approach known as liability-driven investing. LDI assets do not contribute to growth and mostly provide only a partial hedge against changes in liability values. Thus schemes are exposed to a wide range of risks including equity, credit, interest rate, and inflation risk. Rising equity markets and favourable developments in longevity have kept deficits in check. But the current combination of stretched growth asset values and an uncertain outlook for interest and inflation rates suggests that most schemes remain exposed to potential funding instability. A CDI approach tries to solve these problems by making a core investment in a multi-asset credit portfolio. This is held on a buy-and-maintain basis rather than being managed against traditional benchmarks and seeks to fulfil two main objectives. First, to generate sufficient returns to reduce underfunding and increase liability discount rates. Second, to produce predictable and stable income that can be used for matching liability cashflows. For underfunded schemes it is necessary to select assets from a broad multi-asset credit universe in order to capture the yield and duration characteristics that are required to both match cashflows and reduce the level of underfunding over time. Intuitively, a higher degree of underfunding will require a higher allocation to relatively higher yielding assets. CDI has other important benefits. It provides a basis on which to link discount rates to asset yields. It is efficient in terms of governance and maintenance. Risk analysis is simplified. Lastly, CDI is straightforward and intuitive. Cashflow-driven investing is a proven methodology, used at scale by insurance annuity writers. Nevertheless, it is probable that many schemes will be more comfortable with introducing CDI progressively, perhaps based on funding level triggers. Multi-asset CDI portfolios require specialist managers and a solutions-based rather than traditional approach. Karl Tuck Director, Global Client Group UK Coverage karl.tuck@db.com 1 Source: European Asset Allocation Report, Mercer, 2017 For Qualified Investors (Art. 10 Para. 3 of the Swiss Federal Collective Investment Schemes Act (CISA). For Professional Clients (MiFID Directive 2014/65/EU Annex II) only. For Institutional investors only. Further distribution of this material is strictly prohibited. Not suitable for the retail market.

2 CASHFLOW-DRIVEN INVESTING 2 Introduction Despite a strong tailwind from equity market performance in recent years, the sponsors of UK defined benefit pension schemes have had to tolerate stubbornly high and often volatile levels of underfunding. At the same time cashflow management has emerged as a major consideration now that well over half of schemes are cashflow negative. Both issues are becoming more urgent as more schemes close to future benefit accruals or clear the way for defined benefit to defined contribution transfers. For schemes that need to both reduce underfunding as well as boost cashflows it is doubtful that persisting with a traditional allocation to growth and liability-matching assets is the best option. Cashflow-driven investing (CDI) has become widely recognised as a more appropriate investment strategy for schemes in this situation. The merits of CDI have been discussed for some time and CDI is already the default investment approach for insurance annuity providers. Now, with so many pension schemes passing the cashflow tipping point there is a pressing need for them to move more decisively in this direction too. Why is a new investment approach required? Defined benefit pension schemes in the UK have traditionally used a two part investment strategy, allocating in order to grow assets while also matching liabilities. Growth investments are expected to play a long-term deficit reduction role and are usually heavily weighted towards equities as well as allocations to high yield credit and real estate. Liability-matching assets are typically gilts combined with derivative overlays that help to hedge interest rate and inflation risks an investment approach known as liability-driven investing (LDI). Liability-matching assets do not contribute to growth and in most cases provide only a partial hedge against changes in liability values. The net effect is that most schemes are exposed to a wide range of risks including equity, credit, interest rate, and inflation risk. If all goes well there is potential to lock-in funding improvements by reallocating from growth assets to liability-matching assets. On the flip side, in weak markets growth assets have a tendency to decline together with a negative impact on funding. In recent times, strong equity markets and favourable developments in longevity have kept deficits in check despite depressed levels of interest rates and credit spreads. But the current combination of stretched growth asset values and the uncertain outlook for interest and inflation rates highlights the fact that the majority of schemes remain exposed to potential funding instability. Another factor adding to this is the mismatch between the yield on schemes assets and the discount rates used to value their liabilities. Schemes ordinarily use a discount rate based on gilt yields plus a fixed spread. In the case of corporate bond holdings for example, this means that asset and liability values move out of step when credit spreads change. Pension schemes have considerable freedom in setting discount rate policy, but it is hard for them to justify linking their liability discount rates more closely to asset yields when their assets and liabilities are mismatched to such a significant degree. Holding a large allocation to equities is often thought to be inappropriate for cashflow negative schemes because of the risk that equities need to be sold to raise cash to pay benefits. This concern is probably overstated given the deep liquidity of equity markets. However selling equities is not an elegant solution to meeting schemes cashflow needs in any case. The size and timing of equity returns is highly unpredictable and so equities generally sit awkwardly within any cashflow matching framework. There are many differences between schemes but overall the traditional approach to asset allocation leaves schemes exposed to a multitude of risks that lead to funding instability and makes a minimal contribution to disciplined cashflow management. Both these shortcomings are directly addressed by CDI. Cashflow-driven investing explained The basis of CDI is that a scheme makes a core investment in a multi-asset credit portfolio. This is held on a buy-and-maintain basis rather than being managed against traditional benchmarks and seeks to fulfil two main objectives:

3 To generate sufficient returns over time in order to reduce underfunding and increase liability discount rates. To produce predictable and stable income that can be used as the basis for matching liability cashflows. Gilts-based LDI can also be blended in to complete the overall cashflow match and hedge any remaining unwanted exposures. The outcome should be a much tighter dispersion in projected funding levels than would be possible with a traditional allocation to growth and liability-matching assets (chart 1). And from the viewpoint of trustees there is a smaller risk of a large deterioration in funding. Chart 1: Funding status1 Funding status 160% 140% 120% 100% 80% 60% 40% 20% 0% Year 5th-95th distribution cone for CDI portfolio 5th percentile traditional portfolio 95th percentile traditional portfolio Traditional portfolio CDI portfolio CDI has a number of other important benefits: It provides a justifiable basis on which to link discount rates to asset yields (after taking a haircut to reflect potential credit write-offs) and so removes one of the main bugbears of the traditional approach. Discount rate setting can be carried out on a regular basis (perhaps quarterly or even monthly) based on the scheme actuary s assessment of market conditions for credit assets. It is efficient in terms of governance and maintenance. Once the portfolio is set up the primary role of the manager is to monitor the risk of default in the underlying assets and if necessary replace them with assets with a similar income level and maturity date. Because the portfolio is invested mostly in liquid assets it should also be possible to make significant changes to asset allocation if this is demanded by changing circumstances. Risk analysis is simplified. The risk in a CDI portfolio is limited to the probability of default in the underlying portfolio. Portfolios are held on a buy-and-maintain basis and so changes in market price are only important if they indicate a significant increase in the probability of default. Lastly, CDI is a straightforward and intuitive approach. Its basic principles are capable of being readily understood by all stakeholders in a given pension scheme. Insurers are already major users of CDI Cashflow-driven investing is not a new approach. Insurance annuity writers are a pertinent example of CDI s existing large scale use. In general, insurance solutions have a reputation for being expensive and relevant only for well-funded pension schemes. However, it is worth investigating how insurers hedge their annuity books because they have similar objectives to defined benefit pension schemes. That is to say they need to finance the payment of a set of indexed cashflows extending decades into the future. Clearly regulation is a big differentiator between the insurance and pensions worlds. Insurers are required to invest in assets that closely match their liabilities with cashflows. They typically achieve this by applying CDI on a diversified portfolio of both public and private debt. This ensures a strong handle on the quality and timing of their net cashflows, which allows insurers to reduce their balance sheet volatility. It also enables them to link their liability discount rates to their asset yields, producing a further stabilising effect. This seems to suggest that pension schemes should be thinking and acting more like insurers even if they are not well funded. In fact, when it comes to adopting CDI, pension funds may be in a better position than insurers because they are not bound by investment restrictions. This means that pensions can be more flexible and far-reaching in how they implement CDI both in terms of asset type and currency denomination. For example, pension schemes should also be able to select from a broader range of alternative credit assets than are readily available to insurers. Also, pension schemes are able to hold currency hedged foreign investments on a more efficient basis than insurers. 3 1 Source: Deutsche Asset Management, data as of January 2018 For illustrative purposes only. No assurance can be given that the CDI construction process will perform better than other methodologies.

4 This is because insurers are required to hedge foreign exchange risks to the full term of the underlying investments and have to set aside significant amounts of liquid collateral assets such as cash and gilts. This clearly reduces the effectiveness of the strategy in a cashflow constrained environment. How to construct a CDI portfolio As can be seen, at the shorter duration end there would be a concentration of holdings in higher yielding strategies such as high yield debt, emerging market debt, direct lending, and mezzanine real estate debt. The purpose of this part of the portfolio is to provide an early boost to returns. Reinvestment expectations for the surplus cash generated are factored in at the outset. 4 The objective when constructing a CDI portfolio is to generate aggregate income and redemption cashflows that are a good match for the cashflow liability profile of the scheme. In the case of an underfunded scheme it is necessary to select assets from a broad multi-asset credit universe in order to capture the yield and duration characteristics that are required to both match cashflows and reduce the level of underfunding over time. Intuitively, a higher degree of underfunding will require a higher allocation to relatively higher yielding assets. The longer duration end strategies such as ground rents and so on, are used to help offset some of the longer-dated liabilities. Gilts-based LDI is used to fill out the very long-dated tail and bulk up the cashflows right across the maturity spectrum. Chart 3: Cashflow matching portfolio construction1 Chart 2 provides an indication of the spreads and maturities available from a selection of credit asset classes. Chart 2: Investment opportunities1 1,400 Cash flow 1,200 1,000 Credit spread /18 01/27 01/36 01/45 01/54 01/63 01/72 Residual reinvestment risk Yield-enhancing fixed income IG Corporates Liabilities Private Credit Gilts / Risk-free Real assets Security tenor Private Credit A Constructing a portfolio in this way ensures a smooth and logical transition in asset allocation over time. Higher yielding and corporate bond assets gradually run off leaving the portfolio invested mainly in gilts and therefore de-risked and buy-out ready if that becomes the preferred exit route. BBB Yield-enhancement FI Meanwhile, Chart 3 illustrates the broad basis on which a CDI portfolio can be constructed. The foundation is a static holding of long-dated investment grade corporate bonds. Given the size and duration limitations of the sterling corporate bond market this would be global in nature with overseas currency exposure hedged back into sterling. Making the transition to CDI Despite the clear rationale for transitioning to a CDI-based approach it is understandable that many trustees will see this as a radical step that involves giving up on some long-held principles and practices. Many believe that equities are an important diversifier in portfolios and think of credit-based strategies as low 1 Source: Deutsche Asset Management (February 2017) For illustrative purposes only. No assurance can be given that the CDI construction process will perform better than other methodologies.

5 yielding and defensive in nature. However a case can be made that CDI invests in a diversified set of credit strategies and once illiquid assets are introduced the yield on the portfolio becomes quite close to a conventional balanced strategy. Another helpful factor is trustees are generally familiar with many of the alternative credit strategies that are within the scope of CDI. Nevertheless, it is probable that many schemes will be more comfortable with introducing CDI progressively over a number of years, perhaps based on funding level triggers. The approach is flexible enough to be introduced initially for a subset of liabilities. This could either be a proportion of overall liabilities or a particular category, such as pensioner liabilities. Eventual full CDI implementation could then be seen as a self-sufficiency target. The role of CDI manager or adviser Management of a multi-asset CDI portfolio requires specialist manager skills and a solutions-based rather than traditional approach. The extent of the role played by a CDI manager or adviser is likely to depend on the size of the scheme and the level of experience and resources of its investment team. Many large schemes already have direct experience in allocating to alternative credit assets and so might be willing to implement CDI in-house and make asset class allocations to third party managers in a relatively traditional way. Even among larger schemes though there is likely to be limited experience of running buy-and-maintain corporate bond portfolios and so it may be necessary for them to partner with an experienced asset manager for that critical part of the portfolio. Managers could also provide assistance with the overall portfolio build out, cashflow reporting and so on, in conjunction with the scheme s adviser. For many schemes it might make sense for them to work with a single CDI manager that is able to construct the initial portfolio, source the majority of the assets and provide consolidated portfolio analysis and reporting. Such a manager would need to demonstrate that it had a broad credit capability across both public and private markets and possibly also be willing to outsource to third party specialist managers in any areas where it did not have a leading proposition. It would also be very helpful for a manager have an established insurance asset management franchise given the obvious overlaps in style and process. 5

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11 IMPORTANT INFORMATION UNITED STATES 11 This marketing communication is intended for institutional investors only. Deutsche Asset Management is the brand name of the Asset Management division of the Deutsche Bank Group. Global Research Institute is a moniker used by Deutsche Asset Management for the purpose of publishing research. This document has been prepared without consideration of the investment needs, objectives or financial circumstances of any investor. Before making an investment decision, investors need to consider, with or without the assistance of an investment adviser, whether the investments and strategies described or provided by Deutsche Bank, are appropriate, in light of their particular investment needs, objectives and financial circumstances. Furthermore, this document is for information/discussion purposes only and does not constitute an offer, recommendation or solicitation to conclude a transaction and should not be treated as giving investment advice. Deutsche Bank does not give tax or legal advice. Investors should seek advice from their own tax experts and lawyers, in considering investments and strategies suggested by Deutsche Bank. Investments with Deutsche Bank are not guaranteed, unless specified. Investments are subject to various risks, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time. Furthermore, substantial fluctuations of the value of the investment are possible even over short periods of time. The terms of any investment will be exclusively subject to the detailed provisions, including risk considerations, contained in the offering documents. When making an investment decision, you should rely on the final documentation relating to the transaction and not the summary contained herein. Past performance is no guarantee of current or future performance. Nothing contained herein shall constitute any representation or warranty as to future performance. Although the information herein has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. Opinions and estimates may be changed without notice and involve a number of assumptions which may not prove valid. We or our affiliates or persons associated with us or such affiliates ( Associated Persons ) may (i) maintain a long or short position in securities referred to herein, or in related futures or options, and (ii) purchase or sell, make a market in, or engage in any other transaction involving such securities, and earn brokerage or other compensation. The document was not produced, reviewed or edited by any research department within Deutsche Bank and is not investment research. Therefore, laws and regulations relating to investment research do not apply to it. Any opinions expressed herein may differ from the opinions expressed by other Deutsche Bank departments including research departments. This document may contain forward looking statements. Forward looking statements include, but are not limited to assumptions, estimates, projections, opinions, models and hypothetical performance analysis. The forward looking statements expressed constitute the author s judgment as of the date of this material. Forward looking statements involve significant elements of subjective judgments and analyses and changes thereto and/or consideration of different or additional factors could have a material impact on the results indicated. Therefore, actual results may vary, perhaps materially, from the results contained herein. No representation or warranty is made by Deutsche Bank as to the reasonableness or completeness of such forward looking statements or to any other financial information contained herein. This document may not be reproduced or circulated without our written authority. For purposes of ERISA and the Department of Labor s fiduciary rule, we are relying on the sophisticated fiduciary exception in marketing our services and products, and nothing herein is intended as fiduciary or impartial investment advice unless it is provided under an existing mandate. Unless notified to the contrary in a particular case, investment instruments are not insured by the Federal Deposit Insurance Corporation ( FDIC ) or any other governmental entity, and are not guaranteed by or obligations of Deutsche Bank AG or its affiliates. February 2018 Deutsche Asset Management Investment GmbH All rights reserved