There recently appeared on the Global Banking and Finance Review website an article on cash flow-driven investing (YES!), titled “How Can DB pension Schemes Make Effective use of Cashflow-driven investing?” The article summarized a whitepaper from CAMRADATA based on insights shared by industry experts that attended a virtual conference in October.
Sean Thompson, Managing Director, CAMRADATA said, “Cashflow Driven Investing (CDI) is predominantly a bond-focused approach which can be used to try and generate cashflows and increase returns. It can also help reduce funding volatility.” We agree with most of what Mr. Thompson shared. Where we differ relates to his comment about “increase returns.” CDI is all about generating cash flows used to match pension liability payments. A plan sponsor engages in this activity to secure the promised benefit while reducing the funding volatility. The use of CDI should not be driven by the hope of enhanced returns.
In addition to Mr. Thompson’s thoughts expressed above, other key takeaways are listed below. I’ve included the Ryan ALM thoughts on these points in bold, and as you’ll read, we do have a differing opinion on several of these insights.
• As many defined benefit pension schemes are now cash flow negative CDI has become much more important. (We couldn’t agree more.)
• The primary benefit of CDI is the increased certainty of the outcome. (Absolutely) One guest emphasized that for most of their clients, managing short term cash flows was not a challenge. The big uncertainties instead lie five years out and beyond. (We recommend using a CDI approach to cash flow match the next 1-10 years of benefits and expenses. Liquidity is not always available during market disruptions. Why exacerbate a potential loss by forcing liquidity where it may not exist?)
• The breadth of research from managers is important because it brings diversification into the portfolio. (I don’t really know what this means?)
• One guest thought that there would be new developments in CDI pooled products and noted that they were working on new pooled CDI products for smaller schemes that would be well diversified by combining public and private debt, next year. (We disagree… a CDI approach is tailored specifically to a plan’s liabilities, and every liability stream is as unique as a snowflake. It makes little sense to commingle assets when each client has very different liability cash flows.)
• Allocation to illiquid private assets might not suit schemes that are very close (say two years) to the endgame of buyout, but for many other smaller schemes that are further from such an endgame, private assets could be very helpful. (We agree! The use of a CDI approach makes for a more efficient asset allocation by buying time for the alpha or growth assets to grow unencumbered.)
• They pointed out that the probability of default has gone up. This is relevant to CDI and brought the conversation back to credit research and having the expertise to properly stock pick. Credit researchers these days are gold dust: adding that portfolio managers need real-time updates. (Ryan ALM uses mostly corporate bonds in its CDI portfolios providing for enhanced yields and lower cost. However, it does require a commitment to on-going credit research, which is important in any market environment. Ryan ALM puts corporate bonds through a series of solvency filters to determine an approved list of credits.)
• A final point was made on collaborations, with one panelist pointing out that they had been working with a range of pension fund consultancies, to provide more than just fund management to help clients with their de-risking journey towards the endgame. CDI is one path to that ultimate destination. (CDI is the most prudent and appropriate strategy for de-risking a pension since it creates the certainty of asset cash flows with a focus on future value matching of liability cash flows. Duration matching strategies focus on present value matching, which creates an uncertain future value to MATCH benefit payments chronologically.)
As I stated earlier, we are very pleased to see the growing interest in CDI, but there are as many different approaches as there are managers implementing them. As with any investment idea, the strategy is only as good as the firm that implements it. Ron Ryan, and now Ryan ALM, has been engaged in this activity for 4+ decades. We’d be happy to share with you our thoughts on the subject and our unique skills.