PORTFOLIO DESIGN

Investors with Liabilities series: building cashflow-aware portfolios

BlackRock |16-Jan-2018

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

In this issue of Investor with Liabilities we explore the challenges associated cashflow driven investing (CDI). We explore this challenge through the simulated performance of hypothetical, stylised portfolios, which are calibrated to our capital market assumptions.

 


Cashflow driven investing (CDI) is not a new idea for pension schemes, but has gained increasing attention of late as more schemes mature and become cashflow negative. Definitions of CDI vary, but broadly, it is an investment approach designed to increase the certainty of meeting liability cashflows. In reality, it can be challenging to juggle near-term cashflow needs, paying pensioners with long-term objectives, such as ensuring the assets grow to a level that allows future pensioners to receive their promised benefits. We explore this challenge through the simulated performance of hypothetical, stylised portfolios, which are calibrated to our capital market assumptions.

Risk, cashflow and return

We find that the three key letters for solving the conundrum are not C, D and I – but rather, R, C and R – risk, cashflow and return. To build cashflow aware portfolios, investors need a tailored investment framework that considers cash outflows, income, risk and return in combination, rather than prioritising one of those objectives.

Cashflow aware portfolios: potentially better outcomes

Our research highlights that for cashflow-negative schemes financing liability payments through income rather than disinvestment can lead to higher funding levels if there is a market shock.

For poorly funded schemes including income-generating alternatives and shorter dated credit, alongside equity and liability hedging mandates can help create a cashflow surplus in the shorter term. This may be beneficial in dealing with cashflow uncertainty, including the effects of potential transfers out of the scheme, and provide greater flexibility to react to market opportunities. It also appears to offer a greater sharing of risk and return between pensioners and non-pensioners.

Cashflow matching: currently unaffordable for most

The ‘narrow’ view of CDI – cashflow matching through buy and hold investment grade credit is too expensive for many schemes today but may be phased in as funding levels improve and when more attractive entry levels arise. It can be a more equitable form of de-risking over time than phased buy-in, and maintains flexibility in the investment strategy.

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