Return Driven

Our viewpoint

First published in Professional Pensions on 28 November 2019. Click here to see the Professional Pensions version.

Return-driven investment strategies can deliver a better match for scheme-specific return targets via a more diversified and liquid portfolio.

Cashflow-driven investment (CDI) has become a popular approach. Intuitively, putting a primary focus on asset cashflows matching liability cashflows makes a lot of sense. But does it go too far? Can it result in the tail wagging the dog?

We believe that an alternative that puts the investment returns needed at the heart of the investment equation, which we call return-driven investment (RDI), is better for most schemes for a number of reasons.

The differences

A CDI strategy aims to invest in assets that deliver specific cashflows at specific points in the future to pay the liabilities as they fall due. Typically, this means corporate bonds of medium- to long-dated maturities, and gilts.

RDI focuses on the required investment return to meet a specific target, whether that be buyout, "low dependency", or paying all members' benefits. Importantly, it has a more diversified allocation compared to CDI. Cashflows can still be planned and managed using income, but these are not at the heart of the investment thinking. RDI is "cashflow aware" rather than "cashflow driven".

In order to deliver the required investment return, an RDI strategy might contain a broad spread of assets, including equities, real assets such as property and infrastructure, credit, and absolute return strategies, in right-sized allocations in line with their risk levels. A liability-hedging overlay would be in place to manage risk.

For schemes with very high funding levels, who only need minimal returns, it may be the case that little or no growth assets are really necessary, and in those cases the portfolio might be more like a CDI portfolio, but is unlikely to have concentrated holdings in long-dated credit.

For most schemes, we advocate a diversified, risk balanced, liquid strategy as the best way to achieve required investment returns. The equity risk premium is the most evidence-based return driver over the long term, and to ignore or exclude it altogether (as done in traditional CDI) is hard to justify. An RDI strategy also reduces the tail-risk event of credit markets in general delivering a poor outcome.

Advantages of RDI

There are a number of other key advantages of an RDI strategy.

Adjustments: The precision of a CDI strategy can be your enemy, particularly if circumstances change and the strategy needs to change as a result. Members may take transfer values, live longer, or take differing amounts of tax-free cash. Each of these would require an adjustment to a CDI strategy, whereas an RDI strategy (being much more liquid) could be easily adjusted.

Diversification: CDI strategies focus on sterling corporate bonds and, in particular, long-dated bonds. This creates a challenge when it comes to diversification as the long-dated sterling issuer pool is dominated by a small number of sectors particularly financials. RDI strategies will be much more diversified across asset classes, sectors, and countries.

Adaptability: Market conditions, pension scheme covenants, and liability estimates all change significantly over time. What may be an attractive asset strategy today may not be in five years' time. An RDI strategy is liquid so it easily adapts to changing markets and can be optimised along the journey to low-dependency or buyout. It's not reasonable to expect to set a specific investment strategy and for that to be optimal over all periods to meet the required return. With RDI, the level of return and risk can be adjusted straightforwardly with triggers put in place to "de-risk" or "re-risk" as necessary.

Exploiting opportunities

We often see pension schemes that have implemented a CDI strategy, moving towards long-dated credit, similar to how annuity insurers may invest. But we would recommend caution since insurers are regulated to do so, which means that pricing of these assets has become, in our opinion, less attractive.

Currently, there is no material yield pick-up for lending long term compared to short term, which seems odd to us. So as part of an RDI approach, we suggest utilising shorter-dated credit (less than five years) and exploiting this market opportunity until, or if, longer-dated credit gets more attractive.

In conclusion, RDI strategies are, in our opinion, the best way for many defined benefit schemes to deliver their benefit promises and reach their long-term objectives. RDI strategies are robust to both scheme and market conditions changing over time and are flexible to take advantage of attractive investment opportunities or indeed, de-risking, if circumstances turn out better than expected. Many of our clients are now in a strong, stable position as a direct result of following an efficient RDI strategy.

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