USING FIXED INCOME TO HELP DELIVER THE PENSIONS PROMISE: POOLED CASH-FLOW DRIVEN INVESTMENT

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1 INFORMATION FOR INVESTMENT PROFESSIONALS USING FIXED INCOME TO HELP DELIVER THE PENSIONS PROMISE: POOLED CASH-FLOW DRIVEN INVESTMENT COLUMBIATHREADNEEDLE.COM

2 USING FIXED INCOME TO HELP DELIVER THE PENSIONS PROMISE: POOLED CASH-FLOW DRIVEN INVESTMENT Abhishek Srivastav Head of UK Pension Solutions James Waters Client Portfolio Manager, Fixed Income SUMMARY nthe latest challenge to defined benefit pension schemes, and their sponsors, is the prospect of a negative cash-flow position. This is particularly problematic for underfunded schemes nthe answer to matching cash-flows could be a diversified fixed income strategy, which seeks to deliver a fixed percentage pay-out through a combination of capital drawdown/return and investment income, in a closed-ended pooled fund nasset allocation and credit selection remain key skills as part of any manager selection effort, with proven credibility in the assets categories of their offering. In its latest Annual Funding Statement, in May 2017, The Pensions Regulator has clearly set out its expectations of trustees. Irrespective of a scheme s level of maturity, trustees should regularly monitor and assess the scheme s cash flow and have an appropriate cash flow management policy in place. This is particularly important for mature pension schemes, where worse-than-expected market conditions could have a severe impact on the scheme s future cash-flow. Cash-flow Driven Investing (CDI) is a relatively nascent strategy that has been gaining traction among pension funds, asset managers and consultants. Small- to medium-sized pension schemes can work with asset managers and consultants to put a pooled CDI strategy in place which helps them match their cash-flows and thus follow The Pensions Regulator s guidance. 1

3 THE CHALLENGE: SECURING CASH-FLOWS To better understand the cash-flow challenge, some context is useful. Fixed income has long been used by pension schemes to help control various sources of volatility, from helping to immunise portfolios from interest rate risk to dampening portfolio investment risk as a traditional diversifier. The asset class continues to be key for defined benefit UK pension schemes, which are on a path of de-risking as they close and mature (see Charts 1 & 2 below). Chart 1: The number of DB schemes, particularly open schemes, has declined (thousands) % 80% 60% 40% 20% 0% 36% 41% 17% 31% 47% 20% 30% 47% 21% 27% 49% 21% 18% 56% 23% 16% 56% 26% Closed to new members and accruals Closed to new members/open to future accruals Open Chart 2: The number of active members in DB schemes has declined relative to the number of deferred and pensioner members (millions) % 80% 60% 40% 20% 0% 25% 41% 33% 24% 42% 33% 22% 42% 36% Active Members Deferred Members Pensioner Members Source: Defined Benefits: today and tomorrow PPI Briefing Note Number 86 (PPI Analysis of TPR Data), 20/12/ % 43% 36% 20% 43% 36% 19% 44% 36% This relevance is despite the record low yields that characterise markets today, impacting expected returns, as well as being the basis typically used to discount pension fund liabilities. One popular reason for this relevance stems from the duration characteristic of bonds, resulting in the rise of Liability Driven Investing (LDI). Other tailwinds include stricter pension fund accounting and the subsequent removal of the ability to smooth returns (Corridor Method), and the desire of sponsors to minimise the impact of these changes on their financial statements. Lower volatility is also increasingly appealing for maturing schemes as they focus on liquidity and certainty to honour pension obligations. This has resulted in the increased prominence of CDI. Chart 3 illustrates the importance of a pension scheme s asset return journey, where both journeys (Journey 1 & Journey 2) depict a hypothetical pension scheme s asset values over time, with the same start and end values. However, as can be seen, the experience of Journey 2 is far more challenging because of the inability to fully cover pension obligations in Years Five to Ten. Furthermore as can be seen by the gradient of the Journey 2 line, from Year Six onwards, the 14% 55% 29% 18% 45% 37% 14% 52% 33% 17% 45% 38% 13% 50% 35% 16% 46% 38% 13% 48% 37% 16% 45% 39% 13% 47% 39% 13% 47% 40% 2

4 assets need to work much harder to reach the same end goal compared to Journey 1. In addition Journey 2 may introduce the problems associated with the sequence of returns, or Sequencing Risk, where more assets need to be disposed of to meet obligations because they are worth less due to worse market conditions. This ultimately impacts the ability of a pension scheme to achieve its required returns and deliver on the pensions promise. Chart 3: Hypothetical pension scheme asset return journeys GBP Millions Years Pension obligations Journey 1 Journey 2 Source: Columbia Threadneedle Investments For those few closed schemes that are not only of critical mass but also well-funded (see Chart 4 below) and with a strong covenant to fall back on, the meagre yields on offer are less of a concern. Indeed, most have engineered a bespoke segregated solution designed to match the profile of their pension obligations which provides a glide-path to achieving the goal of self-sufficiency or ultimately buy-out. Chart 4: Distribution of s179 funding ratio by size of scheme membership as at 31 March 2016 Percentage of schemes in membership group 100% 80% 60% 40% 20% 32% 36% 28% 17% 38% 41% 14% 40% 42% 23% 43% 28% 25% 46% 24% Over 100% 75% to 100% 50% to 75% 0% to 50% 0% 4% 1 to 99 members 4% 100 to 999 members 4% 1,000 to 4,999 members Membership group 5% 5,000 to 9,999 members 5% 10,000 to over members Source: PPF/The Pensions Regulator, Purple Book 2016, 8/12/2016. Note that the percentages in each column may not sum to 100 because of rounding. However, for the majority of schemes that are not in such a favourable position, the grim reality is often taking more investment risk and/or requiring greater sponsor contributions thereby potentially weakening the covenant. Furthermore for those schemes that are already cash-flow negative, who need to realise assets to pay pensions, 1 the value at which assets can be sold in the future is tied to market conditions at that time. This means that even the planned selling of assets, including bonds prior to their maturity, to meet pension obligations has the potential to further increase investment risk as the exit values cannot be ascertained in advance. In addition, for smaller schemes, there are additional challenges of contending with investment managers requiring a minimum mandate size, as well as the affordability and governance issues associated with hiring a custodian to oversee the assets in a segregated mandate. 1 Mercer highlight that nearly half of DB pension schemes surveyed by them (Mercer European Asset Allocation Survey 2016) are cash-flow negative, and expect this number to rise significantly. Hymans Robertson have also shared research in this regard, flagging that over half of FTSE 350 DB schemes are, or soon will be, cash-flow negative. 3

5 THE SOLUTION One solution that is gaining traction, under the CDI approach, to help schemes in such situations is a fixed income capital drawdown strategy accessed through a closed-ended pooled fund/ commingled vehicle. A fixed income strategy, combining different parts of the credit market, which seeks to deliver a fixed percentage pay-out through a combination of capital drawdown/return, and investment income. Bonds of varying maturities, and credit quality, would be included in such portfolios and held to maturity. Certain benefits of this solution are outlined in the graphic below: Sponsor Scheme Member Greater certainty on contribution requirements One less regulatory challenge Less volatility in financial statements Greater certainty on cash-flows One less regulatory challenge Scope to lower funding ratio volatility Governance benefit Buyout friendly Greater certainty on pensions Greater support for freedoms and choices As the portfolio amortises over time, the ability to hold assets to maturity mitigates the investment risk of divesting assets at unknown values and avoids the associated transaction costs and market impact that can be particularly significant in periods of elevated volatility. It also eliminates any reinvestment risk as the coupons and proceeds from the maturities are used to pay a portion of the pension obligations. These distributions are likely to be paid annually or semi-annually, and while monthly distributions to match pensions in payment are possible it would require portfolios to be of critical mass to do so. Holding securities to maturity also potentially helps reduce the governance burden on trustees by removing the need to make active investment decisions, on the pool of capital allocated, post the investment. Due to the amortising nature of the portfolio, the return will stem from coupon payments and the pull-to-par effect. Accordingly the yield on the portfolio will be a key indicator of return, and viewed in the context of a pick-up versus gilts of similar duration for schemes targeting or discounting returns in such a manner. The amortisation also results in a slightly more nuanced approach to understanding volatility as the portfolio duration changes over the term. There is a high degree of certainty as to when coupon and maturity payments will be made and the amount of these payments, hence mark to market volatility is not realised. In practice however, the value of each security can be marked to market, and could be provided to the scheme for reporting purposes such as in the case of triennial valuations. In order to maximise the chances of achieving the fixed return target, and to treat clients fairly, a closed-ended structure is preferable. This stems from the need to lockin investment returns at the outset. Although entry and exit fees can be structured, a closed-ended format lends itself to this solution from a market returns and administrative perspective to ensure all clients receive the same fixed return and are not disadvantaged due to reasons such as large flows that could lead to dilution or forced selling. 4

6 That said, as the fund and the securities therein mature, the remaining number of securities will continue to fall, resulting in greater concentration risk of the portfolio. This highlights the need to ensure the longer maturity securities in the portfolio are of higher quality. While this measure will help, it won t eliminate the risk. Therefore the options available would be either to transfer the remaining securities to a new version (vintage) of the fund, as part of a larger portfolio, or that the fund is liquidated after the assets falls below a certain level with proceeds distributed to clients. The former may offer lower transaction costs due to the in-specie transfer of existing assets. It may also be preferable for a scheme seeking to continue their cash-flow hedging programme in line with the term of the new fund. Schemes can purchase the number of units/shares in the fund based on the level of cashflow they require and are able to secure. Similar to LDI, the decision as to the exact level of cash-flows to hedge will be scheme specific depending on circumstances such as the funding ratio, cash flow position, covenant strength, market outlook and trustee beliefs amongst others. Of these, particular attention should be paid to the first two factors. This is because as pension schemes reach a negative cash-flow position, the funding ratio drops and it becomes harder to achieve full funding (see Tables 1 and 2 below). The better funded the scheme and/or the better the cash-flow position, the greater the ability to hedge cash flows. That said, the benefit of this exercise is less clear where the scheme is under-funded because a decision needs to be made on allocating capital to either growth assets in a bid to close the funding gap, or to hedge the cash-flows 2. This decision, as is the case for LDI, is in turn impacted by the other exogenous factors mentioned above. A prudent approach to delivering the pensions promise, in our view, should factor in the various risks including those to cash-flows. Table 1: Impact on funding ratio for an under-funded scheme in a negative cash-flow position situation (assuming no impact from market movements or other exogenous factors on assets or liabilities) GBP Millions Assets Liabilities Funding Ratio Start of period % Contributions & Investment Income 0 0 Pensions due End of period % Table 2: Impact on funding ratio in different cash-flow and funding position scenarios (assuming no impact from market movements or other exogenous factors on assets or liabilities, and where schemes are under-funded contributions equally impact assets and liabilities in absolute terms) Cash-flow position Negative Flat Positive <100% funded Worse Same Better 100% funded Same Same Same >100% funded Better Same Better Although the closed-ended nature of the pooled fund enables the fixed percentage pay-out to all clients from an operational and administrative angle, it does mean that clients are tied to the level of cash-flow they decide to hedge at the outset (based on the number of units/ shares they purchase). Source: Columbia Threadneedle Investments 2 A third, not mutually exclusive, option may exist by way of adopting a capital release growth asset strategy to gain beta exposure via derivatives. 5

7 Given that pension obligations will not be uniform over time, as depicted in Chart 3 above, there is likely to be a need to alter the level of the cash-flows hedged over that time. Increasing the hedge could be undertaken by investing in additional vintages, as depicted in Chart 5 below, decreasing the hedge could entail selling units/shares on a secondary market. However, this has yet to develop. Scaling the hedge in this manner will help but will not be as precise as that achieved in a segregated mandate, similar to pooled LDI limitations. This is because the fixed pay-outs from investing in different vintages won t precisely map onto a given scheme s unique liability profile. However, embarking on this exercise will help to secure the route to full funding while acknowledging this is not an exact science. Chart 5: Using multiple pooled funds (vintages) as layers to try and match cash-flows Value ( ) Time Vintage 11 Vintage 10 Vintage 9 Vintage 8 Vintage 7 Vintage 6 Vintage 5 Vintage 4 Vintage 3 Vintage 2 Vintage 1 liabilities Source: Columbia Threadneedle Investments Another implication of the closed-ended structure is fund raising and deployment. On the former, there will be a defined window to commit investments, similar to a private equity style mandate. On the latter, however, all of the client s capital would be drawn down on a specific date and deployed by balancing the transaction entry costs with the market opportunities, typically within a one month period. 6

8 HOW TO CHOOSE THE RIGHT CDI STRATEGY Given that the CDI concept is relatively nascent, trustees should assess a number of factors when comparing offerings. The first is the fund s term, which would be approximately 5-10 years, much shorter than the typical horizon of pension fund cash flows, due to the challenges of forecasting cash-flows beyond this time frame with great accuracy. The forecasting accuracy, and resulting impact on investment horizon for such investments, is also dependent on exogenous factors that affect the membership such as mortality assumptions, and changes to pension benefits, amongst others. This shorter term, relative to pension scheme liabilities, avoids investment in more illiquid and longer term contractual cash-flows (for example ground rents, long lease property, infrastructure etc). This in turn enables an easier transition to buy-out of scheme liabilities and other liability management exercises such as transfer values and cash at retirement. That said, the industry has created propositions to also deal with longer dated cash-flows using alternative assets. The asset allocation mix for the shorter dated cash-flows will depend on the return objectives and risk appetite of the schemes along with the market yields and returns available on the various credit components. They are, however, likely to incorporate a core element of investment grade corporate credit, with additional exposure to high yield, bank loans, and asset-backed securities (ABS), to varying degrees. Some categories, such as bank loans, will be harder to include in smaller funds given the larger minimum trade size. Other options to limit would include callable bonds given the associated pre-payment risk. There also needs to be a decision on the extent of exposure to non-gbp denominated securities. Clearly, access to a broader universe has the potential for greater returns, and diversification. However, it may also entail hedging implications for currency and duration. This, in turn, has cost implications both directly, by way of transaction costs, as well as indirectly, by way of the collateral management required. On the topic of fees, the cost would depend on the complexity of the underlying components and the extent of on-going asset allocation undertaken. The latter should be limited as the strategic allocation and consequent portfolio construction work would be undertaken at the outset and before deployment of capital. Indeed on performance measurement, which can be challenging due to the lack of a standard benchmark, reporting should capture the accuracy of the work undertaken at the outset versus the experience. To this end reporting should capture the accuracy of realised cash-flows versus those estimated, and the management of credit risk. Accordingly metrics such as completion ratios, downgrades and defaults, Yield-to-Maturity, Yield-to-Worst, Option-Adjusted Spreads amongst others would be included. One other area of focus should be transactions as, in theory, there should be no unintended purchases or sales unless there is a need for an unforeseen liquidation or reinvestment. Performance measurement has been a tricky area for other parts of the market such as fiduciary management and even for Buy-and-Maintain strategies due to the bespoke nature of each solution. Accordingly, manager selection should be treated with caution to ensure objective comparisons. One approach to undertaking this exercise could be to include a focus on two critical skills asset allocation and credit selection. On the former, it is imperative to define the allocations to each part of the credit spectrum at the outset, because of the need to hold assets to maturity. Whereas 7

9 the latter is important not only from the perspective to maximise returns but also minimise default risk and therefore loss of capital, given the overarching risk management nature of this exercise. To this end, incorporation and integration of Environmental, Social and Governance (ESG) factors could be helpful. As the industry develops, it may also be beneficial to combine funds offered by different managers in order to access best-in-class skills in different parts of the credit market and across cash-flow horizons. An example: Using an investment of 100mn, with 10mn annual distribution, a closedended pooled Columbia Threadneedle Investments model portfolio would be as follows: Portfolio and target cashflows 12,000,000 10,000,000 Portfolio Target Cashflow 8,000,000 6,000,000 4,000,000 2,000, April April April April April April April April April 2026 Period Start Dates Yield Yield (%) 4 3 Yield Duration (years) Expected Return 1.78% p.a. YTW 1.78% p.a. Distribution 10% p.a. (Years 1-10) OAS 95bps Frequency Semi-annual Credit Rating A Term 10 years # of issuers 109 Duration 5.11yrs # of issues 142 Components IG, HY Structure Closed Region(s) UK Fees TBD Investment Grade (IG), High Yield (HY), Yield-to-Worst (YTW), Option Adjusted Spread (OAS) Source: Columbia Threadneedle Investments, 23/5/

10 CONCLUSION With the inevitable passage of time, defined benefit UK pension schemes continue to mature. The affordability challenge is an issue not only for sponsors but also trustees and ultimately pension scheme members, some of whom potentially face the prospect of reduced pensions. Accordingly, the evolution of hedging practices to cover cash-flows should be of little surprise. To what degree schemes adopt this particular risk management initiative remains to be seen and depends upon numerous factors. We believe more research needs to be undertaken to establish the optimal scheme circumstances to invest in such initiatives. However, as with LDI, the importance of starting the journey should not be underestimated, particularly as schemes move towards a negative cash-flow position. Indeed, CDI can be gradually scaled up when affordable. Well-funded schemes can save the buyout insurance premium by investing like the insurer 3, and under-funded schemes can start to secure cash-flows to deliver on their pensions promise. As experienced in the adoption of LDI, larger schemes have led the way in cash-flow driven investment. Similarly, the industry has attempted to make such solutions more widely available to smaller and medium sized schemes with managers seeking to launch pooled cash-flow driven investment vehicles, such as the one described in this paper. Unlike the LDI market however, there is scope for multiple solutions being combined to access manager skill in different parts of the credit market and across cash-flow horizons. Asset allocation and credit selection remain key skills as part of any manager selection effort to ensure the solution design is robust, and realistic, at the outset to avoid risks in the actual experience diverging from the blueprint. At Columbia Threadneedle Investments, we have managed asset allocation and credit selection mandates since the inception of the firm. As at 31 March 2017, we managed > 107 billion in asset allocation mandates and > 151 billion in fixed income mandates, including > 45bn in managing credit mandates incorporating ESG factors in our process. We continue to work with LDI managers to deliver the solutions our pension fund clients need. 3 There would however be covenant risk till the scheme fully matures. 9

11 To find out more visit COLUMBIATHREADNEEDLE.CO.UK For further details: Abhishek Srivastav Head of UK Pension Solutions Important information: Past performance is not a guide to future performance. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. This presentation is not investment, legal, tax, or accounting advice. Investors should consult with their own professional advisors for advice on any investment, legal, tax, or accounting issues relating an investment with Columbia Threadneedle Investments. This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No , Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. columbiathreadneedle.com Issued Valid to J26591