Mercer | Cashflow-Driven Financing

Mercer | Cashflow-Driven Financing

DB Destination Planning

Cashflow Driven Financing – income-focused investment and funding solution

In this video, Norbert Fullerton, Partner at Mercer’s Financial Strategy Group, considers Cashflow Driven Financing (CDF) as an innovative way to help defined benefit schemes manage funding level volatility and ensure enough income is available to pay members’ benefits when they fall due.

Today, many UK DB pension funds are faced with a huge challenge: how do they invest in a way that helps them to manage risk effectively and still generate the income and returns that they need. They desperately need to become fully funded, on a low-risk basis, so that they can pay all their members’ benefits when they fall due.

Now, a bulk annuity buyout might be a suitable and realistic target for some DB pension funds. But what about those sponsors that don’t want to target buyout, perhaps due to costs or other reasons?

At the same time, nearly 50% of UK DB pension funds surveyed in Mercer’s latest European Asset Allocation Survey are cashflow negative. That’s a big deal. That means that many DB pension funds already do not have enough income to pay their members’ benefits. So, especially in uncertain financial market conditions, instead of focusing only on funding level volatility, it is important to manage cashflows — especially when there’s the risk that pension fund trustees will need to sell investments at a time when asset values are depressed.

So, one interesting way to solve these problems is to have an income-focused investment and funding solution. We call this cashflow-driven financing. First, you invest in bond assets — to meet benefit payments, boost returns and add security. And second, to control the volatility of the funding level and the sponsor’s balance sheet, the discount rate assumption used to value the liabilities is linked to the yields on the bonds held.

Ultimately, under this cashflow-driven approach, you end up with a low-risk portfolio. And, it’s more affordable than a buyout target.

Therefore, it’s a win-win for both trustees and sponsors.

There are three things worth noting when considering cashflow-driven financing. First, think carefully about the make-up of that target cashflow-driven portfolio. For example, how liquid should it be? How much credit risk is tolerable? And how do you intend to manage any residual risks, like longevity, inflation, sponsor insolvency, governance and so on? Certainly, an intelligent and well-designed investment strategy can overcome these risks.

Secondly, think carefully about how and when you transition to a cashflow-driven strategy. Make sure you build in a degree of flexibility to invest opportunistically — so don’t delay when any of the target asset classes become available or the pricing becomes relatively attractive. The windows of opportunity to access some, particularly illiquid credit assets, usually open and close very quickly.

And thirdly, this cashflow-driven approach is not just for very large pension funds with huge internal resources. You can keep things relatively simple. However, if a complex arrangement is more appropriate, or you need more support, then you can delegate appropriately — whether to an active investment subcommittee, an adviser or a fiduciary manager.

In summary, a cashflow-driven financing strategy is different. It’s suitable for sponsors that want to reduce pension funding risks on their balance sheets, and for trustees that want to manage funding level volatility and ensure they have enough income to pay members’ benefits when they fall due.

Read more on Cashflow-Driven Financing in our white paper.

 

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