IN BRIEF

  • Challenged by persistent funding gaps and, for many pension funds, negative cash flow, plans need to move beyond the conventional division between a fund’s matching and growth assets and evolve a more refined set of trade-offs.
  • Funding-led investment addresses this need by breaking down the growth and matching silos and filling out the ‘missing middle’. Through greater use of credit and real assets such as property and infrastructure, it tailors a holistic plan portfolio. The portfolio takes into account both a plan’s liability structure and its cash flow requirements, while seeking to enhance current yields and returns to achieve long-term funding goals.
  • Funding-led investment takes the holistic asset-liability approach through to the ongoing management of the plan, ensuring that all portfolio decisions are framed by an asset liability context as well as prevailing market conditions.

The post-financial crisis era has challenged conventional investment wisdom, perhaps nowhere more dramatically than in the pension sector.

Liability-driven investment (LDI), which served as a powerful tool during a time of falling interest rates and readily available leverage and was widely adopted by pension funds, may be less effective now that rates are rising and leverage is becoming more costly.

Faced with persistent funding gaps and looking ahead to a meagre outlook for economic growth and financial asset returns, traditional de-risking strategies look less affordable, and plan trustees clearly need a fresh approach. Pension funds that once set static long-term strategies and maintained disciplined rebalancing programs must now be much more dynamic within a strategic framework.

The environment is especially difficult for the many funds that are cash flow negative, with benefit payouts exceeding cash contributions. For example, our examination of accounting data for large corporates in the U.S., UK and Europe indicates that roughly three-quarters of the defined benefit plans sponsored by those corporations are in a cash flow negative position, many of them deeply so1 . Mercer’s 2017 European Asset Allocation Study reports that 55% of UK defined benefit plans are now cash flow negative, with 85% of the remaining plans expecting to become cash flow negative within the next 10 years. For underfunded pension schemes, negative cash flow creates an extra drag on funding levels: Each unit of benefit paid represents a bigger proportion of the fund’s assets than its liabilities, so the deficit increases incrementally alongside benefit payments

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