Executive 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 long-term 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.
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