Are You Ready for the Perfect Storm in DB Cash Flows?

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Published on September 15, 2021

| 5 min read

Jim McHugh, Senior Managing Director, Business Development

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Growing liquidity needs and funding deficits prompt Defined Benefit (DB) plan sponsors and their consultants to reshape their portfolios for optimizing near- and long-term cash flows. Today, many DB plans face a “perfect storm” of cash management challenges: a maturing participant base, shortening time horizons, and higher liquidity risk. Building plan allocations dedicated to generating targeted, more predictable cash flows may help increase the odds of meeting your future funding obligations.

Maturing Participant Base

With the continued move away from traditional pensions, almost 80% of DB plans have closed benefit accruals to new employees.1 This locks in a natural maturing participant population. As a result, more plans are entering a decumulation phase, with a growing proportion of participants drawing benefits.

Shorter Time-Horizon

As plans continue to mature, the weighted average maturity of their cash flows becomes shorter; consequently, these plans have less time to recover from poor investment returns or other losses. Combined with negative cash flows, return volatility has a more significant impact on the smaller asset base.

Higher Liquidity Risk

Liquidity risk is also higher. Allocations to alternatives over the last 20 years have grown from 7% to 26% at the expense of more liquid equities and bonds (Figure 1). Alternatives are challenging to value because of assumptions about complex future cash flows and valuation multiples from future sales. Such complexities expose plans to reduced liquidity or unexpected losses upon liquidation.

Less Liquid Alternatives_Fig_1

Cash Flow is King for Today’s DB Plans

Nearly every U.S. public pension plan is cash flow negative today.2 And in Europe, 66% of plans don’t generate enough investment income to meet their current outflows, including participant benefits. Moreover, consultants expect this figure to grow to more than 84% within the next five years (Figure 2).Most Plans Are Or Soon Will Be Cash Flow Negative_Fig_2-1

Some negative cash-flow plans may attempt to sell investments to meet their liquidity needs; however, this is not sustainable over the long term. Further, it risks introducing adverse portfolio effects, amplified by the increased cash flow challenges associated with maturing plans.

First, selling investments can create an added funding drag since underfunded plans with shrinking asset bases need to pay out a larger — and increasingly growing — portion of their assets relative to their liabilities. Second, selling assets when markets turn rocky increases the risk of locking in losses and magnifying funded status volatility.

CDI Solutions Target Income Shortfalls

Given the potential drawbacks of selling assets to meet plan liquidity and funding needs, a growing number of plans are considering cash-flow-driven investment (CDI) strategies. These solutions complement traditional liability-driven investments (LDI) and growth strategies by attempting to address the challenges of mature, underfunded plans: 1) servicing cash flows, 2) hedging liabilities, and 3) delivering returns.

CDI allocations align well with the challenges they intend to address: a liquidity allocation for servicing near-term cash flow needs, cash-flow-matching assets to hedge liabilities, and cash-flow-aware growth for upside return potential (Figure 3). Actively managing these “buckets” of investments across your de-risking journey can help position your plan better for long-term funding needs.Three Components of a CDI Implementation_Fig_3

 

The Growing Role of Dividend-Focused Equities in CDI

The core of most CDI strategies use contractual, cash-flow-matching assets like government securities; unfortunately, underfunded plans can’t rely solely on these instruments to meet their future obligations. What’s more, the interest rate environment we’ve faced over the past decade and the lengthy nature of maintaining DB funding commitments further complicates the challenge.

That’s where adding cash-flow-aware growth to a CDI strategy becomes more valuable. A well-constructed allocation of assets dedicated to cash-flow-aware growth may help strengthen long-term outcomes by tapping a broader spectrum of income-generating securities, such as high yield bonds and dividend-focused equities.

Dividend-focused equities, in particular, can be an essential source of income potential in cash-flow-management designs. This is because these securities have historically offered attractive, relatively stable long-term yield advantages over investment-grade credits throughout the low-rate environment (Figure 4). Plus, they offer the potential for long-term growth.

A Portfolio of Dividend Paying Equities_Fig_4But Dividend Focus Strategies Aren’t Created Equal

Equity dividend income comes with risk, especially the potential for capital loss in a market drawdown. Therefore, carefully selecting a dividend focus strategy is essential to favorable CDI outcomes. Contact us – we can help you quickly breakdown the eVestment universe of dividend focus strategies.

 

1. AON Global Pension Risk Survey, 2019. 2. Brainard, K., & Brown, A. (2020, November). NASRA Public Fund Survey Summary. Retrieved July 31, 2021, from https://www.nasra.org/publicfundsurvey.
2. Brainard, K., & Brown, A. (2020, November). NASRA Public Fund Survey Summary. Retrieved July 31, 2021, from https://www.nasra.org/publicfundsurvey.

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