The fact that cash-flow-driven investing (CDI) has become the latest buzzword is not a surprise. The pension fund industry is changing. This is particularly true for defined benefit (DB) schemes, many of which have matured and are now closed to new members. In the private sector, net contributions into DB schemes turned negative in 2011, and turned cash-flow negative in 2015*. As a result, liquidity management has become a key concern.
The vast majority of DB schemes are focused on how they can better align their investment strategies to generate return, while also paying out their benefits and controlling their cash-flow.
CDI aims to offer long-term, low-risk investment strategies that generate income which broadly matches the expected liability outgoings of any given pension scheme, at a lower cost than a buyout would.
Historically, this has been achieved through the use of investment grade credit and index-linked gilts. While investment grade credit is a part of the solution, the asset class is expensive, and limited in terms of opportunities. It therefore offers poor risk-adjusted returns. The key to success in CDI is to find assets that provide both a return above gilts, while also securing long-term inflation-linked cash-flows. Credit is not the entire answer.
In our opinion, secure income assets offer a better solution. These assets encompass a wide range of strategies across real estate, infrastructure, renewable energy and real asset debt which should generate a better risk-adjusted return over time of 2-3% over index-linked gilts. They offer an attractive cash-flow profile as well, with expected long-term yields of 4% to 5% a year.
It sounds great in theory, but a great deal of care is needed to build a secure income asset portfolio. Assets have to be truly diversified to minimise idiosyncratic risks, while managers have to have a robust process of selection, particularly as parts of the market are currently overpriced due in part to insurance companies buying certain types of assets. Access to best-in-breed managers, and creative thinking, is therefore required.
At Willis Towers Watson’s 2018 Ideas Exchange Conference in London, we demonstrated just how challenging this is to achieve. We asked our delegates, which included CIOs, Investment Committee members and Trustees, to look at four potential assets and to consider whether they would be investible under the criteria of secure income. The assets had to provide a long-term inflation-linked income, while also having sufficient protections in place, for example by having strong counterparties and collateral. We then asked the delegates to consider whether the assets would have low economic sensitivity, and to think about them from an environmental, social, and governance perspective. Finally, we asked them to consider whether the manager of the asset had the necessary expertise and supporting back office function to carry out its role.
The results showed that only 50% of our delegates were able to pick assets that would be successful in all the criteria, demonstrating just how difficult it is to get this approach right. It is why many of our clients have chosen to delegate to us via our pooled fund solution, the Towers Watson Secure Income Fund.
Source: Willis Towers Watson, 2018
Willis Towers Watson has been investing in secure income assets since 2006. We have a 30-strong team focused on identifying some of the best and most appropriate opportunities in the marketplace. The Towers Watson Secure Income Fund is multi-manager and multi-strategy, with more than 75% of assets sourced through Willis Towers Watson-inspired products, co-investments and secondaries. The Fund has over £1 billion in capital commitments, and is well diversified across 9 underlying manager funds and 7 different sectors.
One of the benefits of having an open architecture approach is that we are able to be nimble in our choices – if one part of the market is not offering good value, we can allocate capital to another fairly quickly. Because of our relationship with a large and diverse group of managers, and our market experience, we can include a broad range of assets, and we can be discerning. We only invest in one of every ten ideas that we consider, for example, and often find niche opportunities that offer a better return than the flagship assets that are very competitively bid up in price.
In addition, investors are often disappointed that they’re sitting in long queues to deploy capital, sometimes up to 3 years, whereas our initial investors were deployed in 6 months.
Whatever your approach to CDI, secure income assets should be considered. Strategically, and over time, they can offer consistent long-term cash-flow. CDI may be a buzzword at the moment, but it can offer real solutions with the right analysis and framework. However, relying solely on investment grade credit and index-linked gilts, we believe is not the way forward. Don’t believe the hype, but definitely consider the opportunities.
*Spence Johnson, CDI emerging as UK DB Schemes Turn Increasingly Cash Flow Negative https://www.spencejohnson.com/our-view Last Updated 2017
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