The Cashflow Crunch

Bobby Riddaway, 29 September 2016

The impact of the market volatility experienced since the EU referendum decision is more significant for trustees than preceding periods of market uncertainty for one simple reason: the cashflow needs of defined benefits pension funds have never been greater. The main driver of cashflow needs is the increasing maturity (and thus more pension payments being made) of pension schemes, and the natural change in their life cycle from being a net investor of cash to a net disinvestor. Whilst this is not as a direct result of market changes, the fall in gilt yields to all-time lows has introduced new cashflow issues.

Transfer Values

Many transfer value bases are driven by gilt yields; the fall in gilt yields has led to a significant increase in transfer values. Some members may now be more attracted to a transfer, particularly given increased awareness of the transfer option following the introduction of DC benefit flexibilities in 2015. This could potentially lead to significant outflows of assets, which could have either a positive or negative impact on scheme funding levels depending upon the transfer value basis and the investment strategy adopted. For example, if the investment strategy has a significant proportion of Liability Driven Investment or gilt investment, then the scheme assets would also have risen significantly.

Annuity Prices for Buy-in or Buy-out

In addition to these cashflow issues, the dramatic fall in yields has, in our experience, led to wide variations in pricing from bulk annuity providers. This may make it more attractive for some schemes to disinvest assets to purchase annuities for all or part of their liabilities.

Schemes with Liability Driven Investments

Many LDI strategies are based on leveraged funds. The fall in gilt yields has led to a reduction in leverage, with LDI funds releasing cash to investors to restore the required levels of leverage. For example, if a fund is ideally 3x leveraged, the fall in gilt yields could reduce the leverage to 2 x or 1.5 x, with cash being released  to return to the required level. However, if gilt yields rise, the reverse will happen and funds will need to ask schemes for cash to re-leverage. If schemes do not prepare adequately for such an event, they would have to disinvest assets or see their level of hedging fall.

Coping with liquidity requirements

Pension schemes should review their asset portfolios to ensure that sufficient liquidity exists to cope with any additional cash demands arising from the issues outlined above.

The recent reaction to events in the UK has shown that market volatility can have short term impacts on pension scheme financing.  Schemes needing to move money in the near future from riskier assets to gilts or bonds, or to pay out cash, could benefit,  as currently equity markets are performing well and most Diversified Growth Funds have had a good 5 year run. However, there is another major political event coming up in November; the US election. This could lead to volatility in the stock market. If that is the case, then no-one can predict how long such volatility could last. Schemes should therefore also consider whether there will be a need to sell riskier assets in the next few years and, if so, whether now is the time to move towards other assets that are not so exposed to the equity market.

Summary

  1. As gilt yields have fallen, many transfer values have increased and are becoming much more attractive to members who may wish to exit the scheme. This could cause a cash drain so liquidity needs to be checked.
  2. Buyout prices are showing wide variations now with some insurers more competitive than others. If the likelihood of a scheme buying out benefits has increased, then long term investments, such as DGFs, need to be revisited.
  3. If markets have reacted, in terms of gilts, over a very short period following Brexit, no-one can predict what will happen post the US election. So if schemes will need liquidity later in the year, they should plan for this and not rely on disinvesting from equities. This is especially true for schemes with negative cashflow.
  4. Clients invested in LDI have seen big increases in assets which demonstrates the value of such strategies. However, many LDI funds have released money to schemes to re leverage. If yields rise, they will need to de-leverage again and schemes will be asked for money back from LDI managers, or will see their hedging ratios fall. Again, a check on liquidity is required.


It is always prudent to take professional advice before making any significant investment decisions. Please be aware that this note is a general overview of current circumstances and does not constitute advice. Please do not hesitate to contact your consultant, should you have any questions or if you would like to discuss this issue in more details.

About the author

Bobby Riddaway Head of Investment Consulting

Bobby Riddaway

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