31 March 2016
As a pension scheme matures, it will reach the point where its outgoings (pension payments etc.) are more than its incomings (typically employer contributions) – indeed some UK schemes have already reached this point. Some of the scheme’s assets will then need to be regularly sold to help fund its outgoings.
Some market commentators have recently been making a big splash about this being a concern and encouraging pension schemes to project when this might occur and to take action now specifically in response to this ‘danger’. For example, reference is sometimes made to liquidity risk, or the risk of being a forced seller of equities, or of a need to de-risk into bonds in good time – before cashflows become negative.
But does it really matter?
First, pension schemes hold assets in order that one day they will be used (sold) to pay pensions. They don’t hold them for any other purpose. So selling assets is not a problem. Indeed, it is fully expected for all schemes.
Second, becoming a ‘forced seller’ of equities (and other “reward seeking” assets), might initially feel like a potential problem. What if a scheme needs to sell equities when prices are low? However, it is important to remember that whilst a scheme has been cash flow positive, you could say that it has effectively been a ‘forced buyer’ of such assets. And this is exactly the same conundrum, just in reverse! (If we haven’t been concerned about buying equities over periods when prices might have been high, why should we be concerned about selling equities over periods when prices might be low? The real issue is to do with the volatility and uncertainty of equity prices (both in the short term and long term) – and this is a risk that pension schemes knowingly choose to take - and is not to do with whether we are buying or selling equities at particular times. So this is a known risk, rather than a new problem.)
Third, any projection of when a scheme might become cashflow negative is just that: a projection. The big unknown is future employer contributions. And a lot can change in pension finances even from one valuation to the next, so we shouldn’t rely too much on projections.
Given these points, my view is therefore that many specific actions (eg de-risking timetables) predicated on ‘cashflow negative time frames’ are red herrings. Becoming cashflow negative is not in itself an issue for pension schemes. In fact, it is to be expected.
Having said that, it is of course necessary to make some practical plans for the time when a pension scheme becomes cashflow negative – to ensure that suitable liquid assets are available when needed to pay the promised pensions.
If you do want to increase certainty of cash flow, there are things you can do. First, consider a pensioner buy-in – this will create income to pay your existing pensioners with near certainty. Second, drawing whatever income is available from your assets (dividends, bond coupons and rental income) certainly helps. Third, holding some of your assets in short-dated bonds or floating rate instruments is a better match for short-term benefit outgo. Going further, many of our clients are actually turning illiquidity to their advantage, by investing in illiquid lending funds that mature over a predictable 5-10 year timeframe. As the underlying assets mature they are returned to investors, so there is nothing to sell.
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