Cash flow is king – what schemes can learn from annuity funds

Written By: William Nicoll Co-Head of Alternative Credit, Fixed Income M&G Investments

William Nicoll of M&G Investments looks at annuity funds to see if there are techniques that can be adopted to the benefit of pension schemes

One current topic of discussion is whether pension funds can mimic some of the successes enjoyed by insurance funds, specifically annuity funds, in matching assets to liabilities.

Much of this discussion stems from the fact that an annuity fund and a pension fund have sufficient commonalities to warrant similar approaches to the way in which they invest.

The commonalities tend to be simple and philosophical. Both types of fund exist to provide a regular stream of cash payments to a series of individuals until those payments are no longer required.

The points of difference tend to be practical. Unlike an annuity fund, an open pension fund faces significant alterations to its cashflow and funding positions on a regular basis. And managers of an annuity fund need notworry about their policy holders’ final salaries.

Over the last few decades, the practical points of difference have taken pension funds down a different path to that of annuity funds. The former now tend to have more complex portfolios than the latter, which typically rely on long-dated cashflow generative assets.

Should pension funds invest in the way that insurers do? Could pension funds at least borrow ideas from the insurance sector?

Annuity fund investment
Annuity funds tend to stick to diversified long-dated, often fixed income assets, and hold the bonds to maturity. When sufficient numbers of such assets are not available they will tend to look at other assets. Those assets will only fit the bill if they are capable of delivering the requisite cash flows.

In the case of Prudential’s annuity fund, which M&G manages, these assets tend to be long-dated corporate bonds plus proxies. Such proxies are often in the form of private debt, such as loans made against smaller or local businesses, social housing and infrastructure assets.

Other insurance companies have different allocations to credit and, in some cases at least, proportionately more real estate investments. The differences between annuity funds can often come down to how each company has interpreted the matching adjustment required by the forthcoming Solvency II regulation, which dictates the capital that must be set aside for each asset class and type.

But they all retain the philosophical approach that in order to make long-dated payments, the best choice of asset is a long-dated instrument that provides known cashflows that will cover these payments. If such assets cannot be found, then the closest proxy should be sought instead.

Where it all started
This thinking is over two generations old. In 1952, a man called Frank Redington published a paper in the Journal of the Institute of Actuaries that changed liability management forever.

The document, entitled “A Review of the Principles of Life-Office Valuations”, was a seminal text. It stands out from other influential papers of the time, perhaps because its scribe was not an academic, but in fact chief actuary of the insurer Prudential (now parent of M&G Investments).

It was the first time that the word “immunisation” was applied to portfolios and it earned Redington the accolade of “Greatest British Actuary Ever” years later.

Among other things, he posited protecting portfolios from interest rate risks by matching the assets’ sensitivities to interest rate changes to those of the investor’s liabilities’.

Intriguingly, his less well-quoted conclusions included maintaining a “flexible investment policy to take advantage of special opportunities” and “not letting immunisation theory dictate investment policy”.

Ideas to take into pension fund portfolio management
Managers of and advisers to pension funds have now started to look at this thinking afresh, bearing in mind its ultimate goal of delivering long-term payments that can stand up to interest rate and inflation risk.

There does not seem to be a suggestion that the segregation of pension scheme investments into two buckets, growth and matching, should be replaced. Rather the discussion has focused on whether there are sufficient (and sufficiently simple) opportunities to source and select assets that can deliver the required cashflows to pay pensions without undue complications or risks.

While classic immunisation theory implies that government bonds are the best assets for providing cashflows for taking care of liabilities, today’s thinking around cashflow investment tends to lead pension schemes towards the premium available from credit instruments or assets that deliver pre-agreed cashflows.

Consider that, in the UK, the volume of pension fund liabilities is over £1 trillion, while the market value of outstanding UK Gilts is only £480 billion.

However, adding sterling corporate bonds to the mix, the latter total is boosted to £1.8 trillion. Adding opportunities in private and illiquid credit (assets familiar to insurers) the total is far higher still.

It is worth considering that annuity funds tend to hold 70% of their assets in corporate bonds and 20% in government bonds. However, pension funds tend to hold 26% in government bonds, and just 22% in corporate bonds.

Three ideas that can meet the requirements for cashflows are outlined below.

1) Buy and maintain corporate bond portfolios
This involves investing in a diversified portfolio of public bonds that meets a desired target return, while at least adequately compensating investors for the risks, as judged by rigorous bottom up fundamental analysis. The portfolio’s target is usually agreed upon when the final security is added to the portfolio.

On-going monitoring is essential. It is a misconception that trading never takes place within these strategies. They are certainly not “buy-and forget”.

Should any credit metrics change, the bonds in the portfolio may no longer compensate investors for the risk, in which case, certain bonds should be replaced with better candidates.

2) Private, often illiquid, credit investments
Private or illiquid credit is cashflow investing in its purest form. And this portion of credit markets has three main types of investment: medium-term floating rate assets, long-term inflation-linked or fixed rate investments and more complex assets of varying maturities that pay unusually high returns for the risks.

A portfolio of these assets can generate attractive cashflows, from day one, in excess of those available from corporate bonds.

These additional returns come from not just a credit risk premium, but also from illiquidity, complexity and creation premia.

What is particularly worth considering is, as many assets are floating rate, they inherently protect against interest rate risks without the need for any synthetic instruments. Many others can be long-dated and designed to achieve a desired duration. Others still are inflation-linked, which can be a good match for a pension scheme’s inflation-linked liabilities.

Furthermore, pension schemes are the only major pool of capital that can take advantage of these opportunities in an unfettered fashion. They do not face the stringent regulations that insurers do in the form of Solvency II, they can afford to take sterling risk and they do not have the practical or logistical liquidity restraints prevalent in the defined contribution pension and retail fund sectors. Moreover, such a lack of other sources of demand can mean that the returns on offer are often much more attractive as they have not been competed away.

3) Cash flows from real estate assets
Pension funds have been receiving credit-like risks and returns from underlying real estate assets for some years now. These are typically in sale and-leaseback transactions – investments for around 25 years that give, say, a 4% per annum real return and the possibility of capital growth from the disposal at the end of each property lease.

Insurers have tended to focus more on the cashflows than the property – namely ground rent and income strip investments – because the comparatively high regulatory capital requirements triggered by real estate ownership make them more attractive.

Pension funds can consider all three forms of investment. While each type has its merits, the common thread is that known or pre-agreed cashflows always provide the majority of the returns. And in sale and leaseback investment, even under the somewhat extreme scenario that the property value falls to zero at the end of the lease term, prospective yields still hold up incredibly well compared to non-defaulting unsecured corporate bond equivalents.

From theory to reality
We are already starting to see some of the UK’s pension funds consider their reliance on swap strategies. Indeed some high profile schemes have even started to act, allocating a large portion of their overall allocation to simple and straightforward assets that offer premia for their illiquidity, complexity and the hard work required in their creation. The main reason for such allocations is the ability of these assets, which are of the type outlined above, to deliver steady and stable cashflows from the start of the investment period.

Streamlining the “pension promise”
Liability matching has come a long way since Frank Redington. For those attracted to the simplicity of the annuity fund approach, assets and investments are certainly available for trustees and sponsors to take a sustainable approach to risk across their entire holdings. This may provide them with greater confidence in their ability to deliver the pension promise.