The health of a pension fund is usually assessed on the value of its liabilities relative to the size of its assets, expressed as a deficit or surplus.
However, while pension funds must have in place a long-term plan to make up their deficits over time, the cash flow of a pension fund – its incomings (mainly employer and employee contributions) compared with its outgoings (payments to pensioners) – can be a more pressing concern.
Pension funds ‘mature’ when the amount paid to pensioners draws level with or finally exceeds the amount coming into the fund. For mature schemes still open to new members and accrual, such as the LGPS, it is necessary to maintain a cash flow positive position. The problem is exacerbated by local government’s shrinking workforce, which reduces the number of employees paying into the scheme, and by the increasing life expectancy of pensioners needing payment. Increases in inflation, although likely to be low, must also be accounted for, as pensions increase annually in line with inflation.
At an LGC roundtable, sponsored by Capital Group, fund officers gathered to discuss the latest challenges to maintaining positive cash flow.
Keith Bray, forum officer, Local Authority Pension Fund Forum
Christophe Braun, investment specialist – equities, Capital Group (observing)
Nick Buckland, senior investment consultant, JLT
Rachel Dalton, features editor, LGC (reporting)
Paul Guilliotti, assistant director of finance, Wandsworth LBC
Martyn Hole, equity investment director, Capital Group
Simon Levell, director of consultant relations, Capital Group
Phil Triggs, strategic finance manager - pension fund and treasury, Surrey CC (chairing)
Lorelei Watson, chief technical officer, Hounslow LBC
Duncan Whitfield, finance director, Southwark LBC
Thomas Wilkinson, group finance manager, Dorset CC
Phil Triggs, Surrey CC’s strategic finance manager for pension fund and treasury, chaired the debate. He outlined the scale of the challenge, which varies from one fund to another.
“At Surrey, we have a comfortable cash flow positive situation. In a typical financial year we’re generating £40m more than we are paying out in benefits,” said Mr Triggs.
“One of the other funds in the Border to Coast pool, Cumbria, is probably looking in the region of a £28m-£30m cash flow negative [position]. They have to either take a dividend flow from investment or cash in on certain investments.”
Rather than relying purely on employer and employee contributions for income, funds have traditionally invested a proportion of their portfolios in assets such as bonds and gilts that provide a steady stream of payments to maintain a positive cash flow, and invested the rest in assets such as equities whose value will grow, ideally in line with the value of liabilities.
However, there is pressure on assets that funds traditionally use to provide income, too, as Martyn Hole, Capital Group’s equity investment director, explained.
In the current low-inflation environment, investors have flocked to bonds and the high demand has push bond yields low and in some cases negative.
Mr Hole said bonds’ low yields was one of the three major risks to pension funds with a cash flow problem, and that selling off assets to release cash to pay pensions was no panacea either.
“You’ve got the risk of having to sell assets to pay the pensions at exactly the wrong time,” he said.
“The third risk is that people are living longer and you’ve got the inflation risk as well. Traditional fixed income, unless you buy incredibly expensive index-linked bonds, doesn’t give you that inflation protection.”
Mr Hole said pension funds could look to alternative assets such as private credit and infrastructure for income.
“You can get some very attractive yields from these assets,” he said.
“If you’re investing in infrastructure, those assets can have a contractual link to inflation, if you’re investing in toll-roads or things like that. The problems are that capacity is constrained, often they are expensive, often they are very illiquid, and there’s a high level of governance attached to them.”
High demand has pushed the prices for these assets up too, Mr Hole said: “We had an investment in a Finnish electric utility, which was selling off its distribution assets in Sweden and the market estimate of how much they get for those assets was €5bn; they actually got €7bn because there were so many people wanting to buy them.”
In between traditional assets and high-end alternatives, Mr Hole said funds could look to a “middle” option.
“Look at companies that give dividends and can grow those dividends over time. The advantages are that these assets can pay very attractive dividends and they grow over time, they are liquid and transparent,” he said.
The strategy is not without its drawbacks, Mr Hole explained: “The downside is if you are investing in equities the total returns can be volatile.”
However, volatility is not uniform across all equities, he added. “If you look at companies that are paying dividends and grow those dividends over time, the volatility of those types of shares tend to be much lower than the volatility of the overall market; we’re talking about maybe two thirds of the volatility,” he said.
“There are years when dividends get cut – 2009 is a good example of that – but in general, the volatility of dividends tends to be much lower than that of the underlying prices.”
Mr Hole added that he believes funds looking into this type of strategy should look further than UK companies. He said more than 40% of dividends paid by UK companies are paid in dollars anyway (although investors can choose to receive these in sterling), and added there is “huge concentration risk” in investing only in UK dividend-paying firms.
“Three companies represent one third of all the dividends paid by UK companies: BP, Shell and HSBC. We think there’s a real risk that any of those companies could cut their dividends in the next three years,” he said.
Mr Triggs then invited the roundtable participants to outline their fund’s position in terms of cash flow.
Duncan Whitfield, Southwark LBC’s finance director, said although cash flow was not an immediate concern for his fund, Capital Group’s strategy was “a component part that could be very useful, particularly as we move past the triennial review and whatever that’s going to bring us”.
Paul Guilliotti, Wandsworth LBC’s assistant director of finance, said: “We are £15m cashf low negative so we are in need of income.”
Mr Guilliotti said Wandsworth, in its search for higher income, sold the majority of its gilts last year and invested in multi-asset credit products, which involve investments in high-yield bonds, bank loans, asset- and mortgage-backed securities and emerging market debt.
However, he added Wandsworth was also looking at “alternative strategies” to multi-asset credit, which could include dividend-paying equities or property and infrastructure.
Nick Buckland, senior investment consultant at JLT, described his experience at Dorset, where he was head of treasury and pensions until August 2016.
He said: “One thing I was going to work on within Brunel [the south-west pension pool] were different portfolios that funds could allocate to, and one of those was an equity income, high-dividend structure, because we felt it would be something that would be needed in the future.”
Thomas Wilkinson, group finance manager at Dorset CC, highlighted the difficulty of relying on increasing employer contributions to meet cash flow needs.
“We are cash flow positive still. It keeps on getting to a close stage and then the actuaries come in and save the day with an increase in the employer rate, which employers obviously don’t like,” he said.
“We’re getting a lot of income from other assets; we have direct investments in property,” Mr Wilkinson added.
Lorelei Watson, chief technical officer at Hounslow LBC, said: “We went cash flow negative in 2015-16. I was able to finance it because we have some income; we’ve got some private equity, which is maturing, and we get some property income.”
This wasn’t the only part of Hounslow’s plan to maintain cash flow, however.
“We identified we were going to go cash flow negative two years ago. We had the actuary do a lot of very detailed cash flow modelling.”
She added that Hounslow hired investment consultants to create a strategy to provide enough income to keep cash flow positive.
“We’re going for a multi-asset income fund, which will include equities and it will give us a 4% income flow,” she said.
“It will enable us to pay pensions, but because it is multi-asset it will enable the [fund manager] to switch between sources according to the economic cycle. It will also be able to access asset classes we have no knowledge of like infrastructure and emerging market debt.”
Keith Bray, forum officer at the Local Authority Pension Fund Forum, said dividend-paying equities were “something to be thought about irrespective of your funding position or your liquidity position”.
He added that although high-yield bonds were not a panacea on their own, general understanding of their risks compared to equities had advanced since he ran the Cardiff and Vale of Glamorgan fund in the 1990s.
“In my day, high-yield bonds were called junk bonds and I wouldn’t, to my shame, have touched them with a bargepole, because the moment they were mentioned that was it: you’re a pension fund, you don’t take any risk,” said Mr Bray.
“What I didn’t appreciate at that time was that some of those bonds would have been offering good returns and I would have been turning them down because of the risk of the failure of the company, while at the same time I would have been investing in the equities of those very same companies and taking a bigger risk and not realising it,” he explained.
Mr Triggs said that there was a possibility that inflation would rise as sterling weakened as a result of the Brexit vote. “Could the dividend flow from these equity investments keep up with the pressure that arises from inflation?” he asked.
Mr Hole said: “If you’re looking at inflation between 0% and 5%, which is probably realistic, over the long-term [equities] act as a tremendous hedge against inflation.”
Mr Guilliotti said investments in property and derivatives allowed funds to protect themselves against downside volatility at the expense of some of the upside.
However, Mr Hole warned about the expense and complexity of some of these investments. “One of my colleagues went to a presentation by one of the big investment banks,” he said.
“They had a list of their 20 most profitable transactions that they’d done in the previous 12 months and 10 of them involved pension funds doing some complicated strategy to do some sort of protection.”
Simon Levell, director of consultant relations at Capital Group, said dividend-paying equities should be part of a generally balanced portfolio: “We’re not suggesting funds necessarily increase their equity exposure; we’re just saying, repurpose some of that existing equity exposure to be more income-focused.”
Ms Watson raised concerns about diversity within a strategy investing in dividend-paying equities: “What worries me about just relying on dividends is that if you have a bad year, if you need the income, you are going to have to sell your assets; it’s just a horrifying thought.”
Mr Hole said funds could mitigate this risk by carefully selecting companies, while Mr Levell said dividend-paying equities should not form a fund’s entire income strategy but part of a diversified source of income.
Mr Guilliotti said a fund’s ability to invest more in income rested on the urgency of its need for growth to meet liabilities.
“We’re very much close to [a 100% funding level], which enables us to potentially shift some of the money that was allocated to growth into more income,” he said.
Mr Triggs asked what types of assets, other than alternatives or dividend-paying equities, could help funds maintain income.
High-yield fixed income and emerging market debt were identified as possible alternatives by Mr Hole.
“If you think about Brazilian index-linked bonds, for example, you get a yield on those of about nearly 6% and you’re inflation protected,” he said.
Mr Guilliotti raised concerns about the governance of companies in emerging markets but Mr Hole said this could be overcome by properly researching the companies in which funds planned to invest.
“We’ve only ever invested in one country’s debt without visiting the country and that was Iraq. We didn’t think it was safe to send someone there,” said Mr Hole.
Mr Levell added: “That had an amazing covenant because it was backed by the US government.”
Sovereign debt aside, Mr Hole added that it was important, when investing in emerging market corporate debt, to examine how companies were issuing bonds to ensure their borrowing properly matched the size of their liabilities. Where there was a mismatch here, he said, investors should be concerned about risks to the company’s stability.
He added: “We came across a Brazilian company that issued a massive dollar bond. The real at the beginning of this year was a disaster; it went from 1.55 against the dollar to over 4. Here was this company with an $800m bond on its balance sheet, where its revenues were in reals. They got into some serious financial difficulties with that.”
Mr Triggs asked how, if the UK exiting the EU triggers a recession, funds can protect themselves.
Mr Hole said: “Invest overseas; go global. We think we may well go into a shallow recession in the UK in the next year to 18 months. There are two crucial things to watch: what are UK companies doing in terms of their capital spending plans, and what’s the attitude of overseas investors about investing in UK assets?”
Simon levell portrait
Source: Peter Searle
Expert comment: Middle ground can solve the cash flow challenge
Many defined benefit pension schemes are rapidly moving into cash-flow-negative territory. Income from traditional sources such as gilts and corporate bonds has diminished, creating a gap between the cash flow required and that being generated. The challenge for DB investment has become: how will liabilities be paid, both now and in the future?
Moving from a balance sheet to a cash flow approach
When considering the income that the assets need to generate, there are broadly three main issues to address:
1. Cash flow today in an ultra-low-yield environment
2. Cash flow tomorrow without being forced to sell in down markets and risk permanently impairing the capital pot from which future income is generated
3. Cash flow for a long time in the future as pensioners’ lifespans increase
It is time to consider a new framework and the role that all of your assets play in income generation. In particular ‘the forgotten middle ground’ – higher yielding areas of fixed income and equities – has long been overlooked by pension schemes for its higher perceived risk and lack of liability matching. In an environment where certain good-quality equities offer more yield than investment-grade bonds, as well as future growth potential, it may be time to reconsider what is a ‘risky asset’ based on what it can do to counter the cash flow challenge. Through diversifying income sources in the same way you diversified your liability matching and growth assets, you could find a sensible solution to closing the income gap.
As lifespans expand, asset classes like equities that can be owned in perpetuity and do not carry re-investment risk have clear advantages. In addition to current dividends, equities offer the potential for dividend distributions to grow in the future and for capital values to increase. Although inflation may currently seem a distant prospect, the potential for a degree of inflation protection through owning the rights to earnings from productive assets has long-term attractions.
With many UK DB pension schemes becoming increasingly mature and moving to cash-flow-negative territory, there is a need to reconsider investment strategy and to prioritise income and cash generation rather than simple capital appreciation, or return over a benchmark. We would suggest that the ‘forgotten middle ground’ could offer income without compromising on liquidity, transparency and capacity.
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