LDI - the danger of negative cashflow | Pensions - Aberdeen Asset Management
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July 28, 2017

LDI – the danger of negative cashflow

by Marius Penderis, Senior Investment Manager, LDI Team

As pension funds mature, the various risks they face alter in magnitude. "Traditional" risks such as longevity, interest rate and inflation risk are generally well understood and the target of risk reduction programmes. These risks can also reduce naturally as the maturity of pension schemes increase. However, other, perhaps lesser-known, risks such as drawdown risk increase with fund maturity. As net scheme cashflows turn increasingly negative, pension funds would be well advised to pay more attention to drawdown risk and this is the subject of this briefing paper.

Because pension funds have mostly closed to new entrants and accrual, the cashflow balance is in a process of rapid change. The situation today can be dramatically different compared to even 5-10 years ago. When schemes were still open to accrual and even new members, contributions relating to active members and the yield on invested assets (equity dividends and bond coupons) together were typically sufficient to pay for outgoings relating to retired members.

ldi c 1

Source: AAM. Example mature pension fund cashflows. Ignores deficit reduction contributions.

Deficit reduction contributions from sponsors aside, a fund that has closed to accrual will have no contribution income and must rely on asset income and redemptions to meet all benefit payments and expenses. Recently enacted pension freedoms have made the situation even worse, members taking transfers to DC schemes can exacerbate cash shortfalls.

ldi c 2

Source: AAM. Example mature pension fund cashflows.  Ignores deficit reduction contributions.

Negative cashflows presents a large potential risk for pension funds. If assets need to be sold at times when asset prices are depressed then a greater-than-expected proportion of the assets will be sold and the remaining assets need to work harder than expected to make up the difference. In these circumstances, assets could well prove insufficient to meet liability payments, even if asset prices subsequently recover. We call this "drawdown risk": the risk of being forced to sell extra assets when they are depressed in price and then missing out on a subsequent recovery on those assets.

The problem in numbers

For example, let’s say a company is obliged to pay a supplier £10,000 in exactly one year’s time and another £10,000 in two years’ time. It expects to earn 2% per annum on a diversified investment portfolio and sets aside £19,416 to cover its future payments. If, however, it earns -8% in the first year (10% less than expected), it will only have £7,862 left in the pot after the first annual payment. For this to grow to £10,000 by the end of the second year would require a return of 27% over the second year (25% more than expected). The impact of negative returns has been magnified by negative cashflows.

Expanding the example to a fairly mature pension fund, with a liability duration of 15 years, the chart below shows examples of what happens to its funding level under different return patterns, all of which average to the same return over time. At outset, the fund holds sufficient assets to meet its liabilities if a required real return of 2% pa is achieved. However, by introducing volatility to the required average return, e.g. 7% below the requirement one year followed by 7.5% above the following (to make sure that the average is regained), a sizeable deficit can arise over time. We have chosen a fairly modest degree of average return deviation of 7%. The average annual return deviation of the FTSE All-Share has been 13% over the 31 years to 31/12/2016, with a standard deviation of 15.6%. We scaled down the variability to allow for a broader mix of assets but note that the variability of long-maturity bonds also contributes to drawdown risk in a negative cashflow scenario. The greater the deviation experienced in capital values of investments, the greater the potential deficit.

ldi c 3

Source: AAM. Simulated pension fund solvency scenarios.

The "Down one year" line in the chart above shows that the impact of just one year of sub-par investment return accumulates over time, even where the return difference is immediately offset in year two to put the average return back on track. The impact of two years’ sub-par performance at outset is materially worse ("Down two years"). The worst outcome is in fact the one that is most akin to reality, a regular see-sawing of returns, starting with a below-par year. The "Rise one year" line shows that the risk is symmetrical on the upside; if the initial return is better than expected, the excess assets created accumulate over time even where there are subsequent offsetting down years. The spread of the lines indicates the magnitude of this unrewarded risk (there is no inherent return expectation associated with drawdown risk and pension funds could be lucky or unlucky).

The key message is that liability payment commitments become risky when asset returns are volatile. Paying out a fixed amount from a depleted asset base leads to the remaining assets having to return ever-increasing amounts, and vice versa.

What to do

The solution is to include cashflow management in a holistic LDI solution. For drawdown risk in isolation, it is to hold bonds and other cashflow-generating assets that provide sufficient cashflow to match the liability payments, thereby avoiding the need to sell down assets that might be impaired. Because these bonds are planned to be held to maturity, an ideal candidate is a portfolio of investment grade credit that is matched to the liability cashflows, on a buy and maintain basis. Investment grade credit provides a high degree of certainty of delivering the required cashflows, together with a useful pick-up in yield compared to government bonds or swaps. Any sudden increase in credit spreads is not going to derail the projected cashflows, as long as the bonds can be held to maturity.

Traditional LDI on its own does not fully address the risk associated with negative cashflows. Note that simply investing in bonds that have the same average sensitivity to interest rates as the liabilities does not necessarily solve the problem. If long-maturity bonds need to be sold to fund short-term liability cashflows then the problem still exists. Traditional LDI remains an essential tool that provides a mechanism for funds to retain growth assets whilst gaining exposure to long-maturity bonds or swaps to reduce interest rate and inflation risk. This requires a judicious use of leverage. To address drawdown risk as well, some of that leverage can be given up to accommodate a greater holding of shorter-maturity bonds.

At Aberdeen Asset Management, we advocate a holistic approach via a blend of traditional LDI and buy and maintain credit which, together, can manage interest rate and inflation risk but also drawdown risk, whilst still facilitating the use of other growth assets. This structure does not necessarily permit the same degree of leverage as traditional LDI but, as pension funds mature and move towards their chosen end game (buyout or self-sufficiency), reducing leverage should be one of their ambitions.

Conclusion

Drawdown risk is perhaps something that is not yet a focus of the majority of pension funds. However, as they mature, this risk is becoming more and more significant. There is no inherent reward for taking drawdown risk and, given that pension funds should be risk averse (members and trustees should be far more concerned about deficits than the pleasure they might get from surpluses), this represents another risk for pension funds to manage.

Including a suitable portfolio of shorter-maturity bonds that can provide the cashflows to match the expected liability payments can mitigate drawdown risk whilst retaining the benefits of traditional LDI. The buy and hold nature of this portfolio lends itself to buy and maintain credit.

Marius Penderis
Senior Investment Manager, LDI Team
Aberdeen Asset Management

Image credit: Shutterstock

The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.

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Risk warning:

Risk warning

The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested.

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