Inevitably, there will come a time when your scheme starts to pay out more in benefits to retirees than it receives in contributions from active members. Exactly when this will happen will be very scheme specific. It will depend upon various factors such as:
the age profile of active and deferred members,
whether the scheme is open or closed and,
the proportion of the overall membership that is already retired.
However your scheme is shaping up, you’ll need to plan ahead.
It is critical that your investment strategy is structured in a way that reliably generates the required cash whilst maintaining or improving your funding ratio. At the outset, you should assess the required return of your assets, the length of your journey plan and how much reliance you can place upon contributions from your sponsor.
Properly prepared, you can keep on track towards your end-game whether you are anticipating buy-out or aiming for self-sufficiency.
Illiquidity premium in secure income
A good investment for a cashflow portfolio will generate both a predictable income and reliable returns.
Some of the highest returning investments that fit the bill can be found in private markets. These include: infrastructure debt, ground rents, social housing, real estate debt and direct secured lending. These types of investments are called ‘secure income’ assets.
Credit risk amongst secure income assets is generally low. The relatively high return is largely explained by their less liquid nature, with the average holding period of between 5 and 10 years.
There is a trade off: while illiquid assets can offer higher returns, they could limit your future flexibility, leaving you with assets which could prove expensive to sell should your scheme’s requirements change.
As a result, adding secure income assets into a cash-matching portfolio requires careful consideration of your scheme’s need for returns, its length of journey plan, end-game strategy and, the reliance that you can place upon your sponsor.
Importance of the covenant
When the risk profile of your scheme’s investment strategy changes, the balance of risks that are being taken by your scheme and your sponsor will change too. It is the sponsor that is the ultimate underwriter of the risks that the scheme carries.
When you make an allocation to a cashflow matching portfolio, your scheme will generally be taking less investment risk and more liquidity risk.
A cashflow portfolio will have characteristics, principally interest rate sensitivity, that makes it an integral part of your liability hedging structure.
However, the typically smooth profile of an actuarial estimate of any scheme’s future cash outflows cannot easily be replicated using cash-matching assets alone. Bespoke cashflow portfolios are unlikely to be achievable for all but the very largest of schemes.
This need not be a problem; a bespoke LDI portfolio working alongside a cashflow portfolio can do all the fine-tuning. A bespoke LDI portfolio is achievable at a much smaller scale.
To retain an accurate hedging result, close co-ordination between your LDI and cashflow portfolios is vital. Effectively, they should be able to ‘speak’ to each other.
This is why we holistically manage cashflow-matching and liability matching assets all and under one roof.
Credit at Cardano: An interview with Justin Hatch
In November 2021, Justin Hatch joined Cardano to strengthen our internal credit capabilities. Justin’s first task is to develop the core of Cardano’s cashflow portfolios focusing on investment grade credit. This will complement our existing capabilities in Liability Driven Investing. Having worked in the credit market for more than 25 years, Justin has successfully navigated several credit cycles and financial crises. And still, after more than two decades, the credit markets continue to fascinate Justin. “Markets are constantly changing and no two days are the same.”
According to Justin, investing in credits is similar to solving puzzles where the pieces are changing shape over time. “It is exciting to make the analysis and adapt as new information becomes available. It gives me a great satisfaction when longer term positions come to fruition.”
In this interview, Justin explains more about cashflow matching, navigating credit cycles and what plans are afoot.