Cash Flow Matching =/= The UK Pensions Crisis

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

I just returned from attending the IFEBP Annual Conference in Las Vegas, NV. First, it was great to have the IFEBP attendance back to pre-Covid-19 levels. There had to be more than 5,000 attendees. Congrats to the IFEBP for continuing to provide quality education to both the multiemployer and public pension trustees, administrators, and a host of other essential personnel.

I am always thankful for the opportunity to speak/teach at these events. During one of my sessions titled “Public Plan Investment Return Assumptions”, I was asked a question related to the UK and Cash Flow Matching and if the former was caused by the latter. Simply, the answer is NO. I did share that Cash Flow Matching (CFM) is but one arrow in the LDI quiver, but that it was a strategy known as duration matching and specifically duration matching using derivatives and leverage that nearly brought the UK’s pension industry to its collective knees.

As we’ve previously reported, leverage among UK pension plans was in far greater use than what we witnessed in the US. It was highlighted in numerous articles that plans were leveraged up to 7X. Duration strategies are primarily used within private corporate pension plans and levered exposure is used much more in the UK. As a reminder, duration strategies are trying to minimize (neutralize) interest rate movements between a plan’s assets and the plan’s liabilities. In duration-matching strategies, longer-dated bonds (primarily Treasury STRIPS) are used to accomplish this objective since the longest duration coupon bond is around 16 years. Key rate durations may also be used as a string or ladder of duration targets.

With regard to cash flow matching, corporate bond cash flows of principal and interest are optimized to match the plan’s liability cash flows chronologically. This strategy dramatically improves a pension plan’s liquidity to meet those monthly payments without having to force liquidity in asset classes that might not possess the necessary liquidity at that time. Furthermore, with cash flow matching a plan gets duration matching. With duration matching, you are not getting the necessary liquidity to meet benefits and expenses. In addition to the enhanced liquidity, a pension plan is mitigating interest rate risk for that portion of the portfolio using CFM, as future value benefits are not interest rate sensitive. There are other benefits from CFM, including the “buying of time” for the remaining assets (growth) that can now grow unencumbered.

The question of CFM’s role in the UK pension debacle was a good one. I was extremely pleased to be able to answer that there was no role for CFM. I’m also pleased to mention that rising US interest rates are creating an incredibly positive environment for CFM in which we at Ryan ALM are constructing portfolios that produce yields right around 6%. For more information on CFM, duration, and their differences please visit Ryan or call us at 201/675-8797.

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