When corporate pension funds have to start writing bigger checks to retirees than they’re pulling in from the front office, it’s time to start investing a little differently.
That’s why J.P. Morgan Asset Management, Janus Henderson Investors, and other money managers are pitching so-called cash-driven investing as one technique pension funds can use to mitigate the side effects of negative cash flows, or when a plan is paying out more in benefits to workers than it is getting in cash contributions.
Cash-driven investing involves building a portfolio so it can generate enough cash flows to meet expected liabilities, while also improving the stability of funding levels. The strategy helps declining pension plans better tolerate market downturns by mitigating the risk of having to sell assets at a bad time.
Defined benefit pension plans for private sector employees have been in decline for decades as companies have reduced benefits for newer employees and switched them into 401(k)-type programs. Recently, U.K. plans hit a tipping point, with a big slice of the industry paying out more than it is receiving in contributions. According to Mercer, 55 percent of U.K. defined benefit plans are now experiencing negative cash flows, up from 42 percent last year. The same phenomenon is happening in the U.S., albeit more slowly.
Asset managers are eager to help plans deal with their precarious situations. Sorca Kelly-Scholte, JPMAM’s head of pensions solutions and advisory for Europe, Middle East and Africa, says the situation is even more stark for those pensions that are already underfunded, meaning they don’t have enough in assets to meet their obligations.
“It amplifies funding volatility,” she explains. “If you have to sell assets to service cash flows during a market downturn, then you could lock in losses.”
As a result, the need for pension funds to generate income and liquidity will become even more important so they don’t have to sell at inopportune times, Kelly-Scholte adds.
To that end, JPMAM is developing a new multi-asset investment strategy that uses credit, government bonds, real estate, and other assets to do both liability matching and hedging. Kelly-Scholte says European plans, for one, need to add more credit instruments to their portfolios, as well as income-producing real estate and infrastructure investments.
Right now, many European plans have a liability-driven investment strategy in place, simply matching the duration of their assets to their liabilities. What’s happened as a result is that they are generally under-weight when it comes to credit, in part because of the immaturity of the European bond markets, as well as real assets, she says.
In January, Janus Henderson Investors launched what it calls a cash-flow driven investment strategy for institutions. The credit-based strategy is aimed at helping defined benefit plans meet their cash flow needs without having to potentially sell investments during a market crisis or alternatively having to hold a lot of cash.
U.S. plans, which have more in credit assets that their European peers, will need to add more infrastructure and real estate. Pension plans might be contracting, but there’s a lot of upside for asset managers. According to Mercer, only 4 percent of pensions have adopted a cash-driven investing strategy.
