A fly In The Ointment?

We are huge fans of cash flow driven investing (CDI). We believe that securing pension benefit payments is the number one objective for a DB plan. Maximizing the efficiency of the asset allocation process is also critical, especially for those pension plans focused on achieving the ROA. Plan sponsors and their consultants use CDI approaches to match every cash flow net of contributions (the first source to fund benefits) each month from the next payment to as far out as their program allocation can afford to go.

Most CDI implementations favor the use of publicly traded bonds, as they are the only instruments with a known terminal value allowing for the greater efficiency in matching those monthly payments. This universe may include Treasuries (lowest yielding), agencies (prepayment risk), and investment grade and high yield corporate bonds (credit risk). In some cases, senior secured debt, bank loans, and other private investments have been used sparingly to potentially enhance the yield reducing the overall cost to implement the strategy.

We are also aware that some investment managers are incorporating dividends in their attempt to capture many sources of liquidity within an overall plan. However, we would caution the use of dividends to help secure benefit payments, as dividends are not guaranteed. The current environment is a perfect example of companies that are cutting or eliminating their dividends. It is too early to know the full extent of the impact, but it has been substantial. As a point of reference, in the great recession, nearly $100 billion in dividend income was lost in 2008 and 2009.

The uncertainty surrounding dividend payouts makes the securing of benefits very difficult, if not impossible. One way to overcome this issue is to accumulate a significant reserve to meet those futures payouts, but given where yields on cash are in this current environment that is a less than desirable implementation. Corporate spreads on investment grade and high yield bonds certainly widened considerably early this year, but they have narrowed significantly since March. In addition, widening doesn’t impact the semi-annual payout of the interest, and in fact, made for a greater cost savings with any new money coming into the program. Don’t hesitate to reach out to us if we can help you create an efficient CDI program.

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