J.P.Morgan Asset Management’s Sorca Kelly-Scholte on how pension schemes can meet their cashflow needs and plan for the future
UK pension funds could be reaching a “tipping point” into cashflow-negative status, data from the Office for National Statistics suggests. Sorca Kelly-Scholte, Head of EMEA Pensions Solutions & Advisory at J.P.Morgan Asset Management (JPMAM), presents the case for cashflow-driven investing at a time when most schemes are underfunded and need to grow their investment returns to meet future liabilities. Kelly-Scholte also reveals how JPMAM worked with a German client with a mature defined benefit pension scheme that was looking to move away from an aggregate portfolio towards a holistic pension solution.
investment, rather it works alongside it
Many schemes are getting to the point where they are paying out
Why are increasing numbers of schemes becoming cashflow negative?
How can cashflow-driven investing (CDI) help these schemes?
Cashflow-driven investing: Securing liquidity for payments
Head of the EMEA Pensions Solutions & Advisory Group
What are the key challenges faced by schemes that are cashflow negative?
The first challenge is that, if you are underfunded, it will create additional drag on the funding level rate. For example, in a scheme scenario of 3% negative net cashflow and a funding level rate of 90%, you will probably expect to see funding levels fall by around 0.33 percentage points each year. That might seem small but, at a time when funds are already struggling to repair deficits, it counts over the longer term. The second challenge is that being cashflow negative tends to amplify volatility. If you are compelled to sell assets to pay pensions, then you’re becoming a forced seller. That locks in losses. You might say, of course, that it might also lock in gains to the upside. That’s true but overall it has the effect of making the funding level more volatile. The third challenge is working out how to service the cashflows and determine which assets to sell. Alongside this is the governance and administrative burden of figuring out how to rebalance the portfolio.
UK defined benefit pensions are increasingly tipping into negative cashflow, with a growing need to pay out cash to meet obligations. However, at the same time, most of them are underfunded and need to grow their investment returns to meet future liabilities. Sorca Kelly-Scholte, Head of EMEA Pensions Solutions & Advisory at J.P.Morgan Asset Management, reveals here what schemes can do to consider their cashflow requirements and meet the funding challenge.
How can trustees measure the success of a CDI strategy?
Some of the traditional measures of success will remain in place such as: is the funding level travelling in the right direction? Is the volatility of the funding level coming down to acceptable levels or within expectations? Then there are a number of other metrics that you need to look at, particularly around the buy-and-maintain portfolio. You need to be looking at the success of the manager in maintaining the credit quality of the portfolio and maintaining the required duration characteristics. Also, are they delivering the cash flow that’s expected from that portfolio? You also want to look at the degree of turnover in the portfolio; the idea being that if the manager is successfully choosing the right funds in the first place then the turnover will be low, and the rate of downgrades or credit impairment in the portfolio will be low.
What types of assets can be considered for a CDI strategy?
As mentioned earlier, central to a CDI strategy is a buy-and-maintain high quality credit type portfolio. To secure cashflow, we want to be using high quality credit, where we can be confident that we’re capturing and delivering on that cashflow. In order to properly diversify the credit risk, and also to achieve yields and help to work towards those long-term return goals, you should also think about credit globally, rather than restrict it to the domestic market. The US credit market in particular just dwarfs the sterling credit markets and gives you much greater depth, liquidity and diversity in order to build these types of portfolios. After that, you are looking at income-generating assets and that will take you to more liquid types of credit. These include private lending, commercial mortgage loans, emerging market debt; high yield can be income generative, although you don’t want to be relying on these assets for principal repayments. All of these have a role in helping to deliver a base level of income that can go towards servicing cashflows. It is about finding the right balance and ensuring you’re servicing the cashflow but also having capital to put into those long-term return opportunities.
How do CDI strategies work alongside liability-driven investment (LDI)?
Cashflow-driven investing doesn’t obviate the need for liability-driven investment (LDI), rather it works alongside it. It also uses credit as a venue for duration hedging, lifting some of the burden of that task from traditional LDI strategies and accordingly reducing reliance on leverage to hedge duration.
Cashflow-driven investing aims to secure liquidity for payments while preserving the ability to generate return. In today’s environment where we are seeing low yields, pension plans need to start using principal payments on fixed income in order to generate the required cashflow as well. The best route is to buy and hold bonds to redemption and use those principal or redemption amounts to meet your cashflow requirements, as well as the income. The core of the CDI strategy is going to be these buy-and-maintain fixed income or credit-type strategies. Around that you can build other strategies for general income and, of course, long-term growth and return.
As schemes are increasingly closed to new members and future accrual they are maturing rapidly. Many schemes are getting to the point where they are paying out more than they are receiving in contributions – becoming increasingly cashflow negative as they mature.
more than they are receiving in contributions – becoming increasingly cashflow negative as they mature
Cashflow-driven investing doesn’t obviate the need for liability-driven
Cashflow-driven investing: Guiding principles
Equity and real assets
Buy & Maintain credit
Source: JPMAM. *As at 30 September 2017
Non-contractual cashflow and total return
Source: JPMAM. As at July 2017. Chart above shows an illustrative cashflow driven investment strategy.
Contractual cashflow and enhanced yield
J.P. Morgan Asset Management use a multi-asset approach to cashflow-driven investing, anchored on three guiding principles: service cashflows, generate return and hedge liability risk. These three principles are designed to meet the diverse and evolving needs of defined benefit pension schemes. The group has a long history of success in this area, with a specialist pensions and insurance analytics team that works in close collaboration with a dedicated pension and insurance portfolio management team. JPMAM’s liability-aware business has grown over the last several years to over GBP 33 billion* globally, a reflection of not only their client’s confidence in them but also a de-risking pensions market. JPMAM have grown significantly in the insurance asset servicing market, which employs a different liability management discipline. The group’s AUM growth was primarily attributable to customised fixed income mandates, where their UK Buy/Maintain team specialises. All portfolios are bespoke and built against a scheme’s particular liability and are designed to help the scheme sustain and enhance funding status.
INCOME AND GROWTH
A Core credit portfolio comprised of high-quality, investment-grade credit and sovereign debt provides duration and liquidity in order to stabilise the scheme’s balance sheet, while servicing pension payments.
Core + Core Plus - Domestic
An Income and Growth portfolio of equities and real assets is designed to provide total return from income-generative growth assets.
Core + Core Plus - Global
A rolling portfolio of shorter-duration Core Plus assets, including direct lending, high-yield credit and leveraged loans, provides cashflow generation in the immediate term, while enhancing the portfolio’s yield.
Income & Principle+
Building diversified CDI portfolios
Over the past decade, UK pension schemes have engaged in a consistent programme of de-risking from growth-focused portfolios to LDI strategies designed to reduce short-term balance sheet volatility. Many schemes have relied heavily on the gilts and derivatives markets and on leverage to de-risk. Now, half of UK defined benefit pension schemes are paying out more cash than they are bringing in through investments and contributions. This means pensions must look beyond UK centric fixed income exposure to globally diversified multi-asset solutions better aligned with shifting needs. By pivoting to a cashflow-driven investment strategy, as illustrated by the chart, below, schemes can access a diversified mix of income- and return-generating assets that can help them to improve their funded status and meet obligations over time.
High yield, private credit, core real assets
LDI and collateral
Liability cashflow projection
• Mortgages • Infrastructure debt • Direct lending • High yield and leveraged loans
• Equity income • Infrastructure equity • Real estate
• Investment-grade emerging market debt • Investment-grade credit • Gilts • Cash & swaps
Secure cashflow and duration management
NEED TO KNOW
Hedge liability risk
Beyond UK centric fixed income exposure
Source: JPMAM. For illustrative purposes only. Mortgages includes mortgage-backed securities, residential mortgage-backed securities, covered mortgage bonds and real estate debt. High-yield debt includes emerging market high-yield debt.
Our comprehensive cashflow-driven investment strategy brings together a wide range of asset classes that play specific roles in meeting cashflow needs and generating returns. These can also be separated into three key portfolio building blocks: core, core plus and income and growth.
Expected risk/return profile
Balancing pension scheme needs
Mulit-asset Portfolio Solutions
Source: JPMAM analysis as of 31 March 2017. The three solutions provide 15 years of cashflow matching and immunise the pension plan’s balance sheet from interest rate changes along the curve. Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. Past performance is not a reliable indicator of current and future results.
Sorca Kelly-Scholte says: “We worked with the scheme’s actuary to separate the scheme’s liabilities into those covered by a direct insurance asset and those retained within the scheme. We also established a proxy for the discount curve that would be applied by the scheme’s actuary to ensure that the liabilities constructed were in line with the valuation methodology of the scheme. Taking this view on liabilities allowed us to identify the extent of the duration mismatch within the scheme.” The end result has been a positive restructure. Indeed, the portfolio has been significantly reshaped to better align with the schemes liabilities. The portfolio includes a new asset class in Emerging Market Investment Grade Debt (8%) – split across corporate and sovereign bonds. The equity exposure has been significantly reduced (from 30% to 17%). On the fixed income side, the allocation to USD denominated debt has also been reduced (from 35% to 23%) while the allocation to EUR denominated debt has been increased (from 35% to 58%). Overall we increased the allocation to credit and reduced exposure to government bonds. The implementation of the fixed income allocation is distributed through a bespoke buy-and-maintain approach that invests in segments of the market by rating and maturity. This bespoke approach allows JPMAM to better match the assets of the pension plan with the liabilities they are required to fund. This is the fundamental building block of funding-led investment; ensuring that assets are invested in-line with the liabilities they fund.
meet pension payments due over the next decade
1. Re-engineered the fixed-income allocation to a bespoke, buy-and-maintain mandate, which:
Invests across corporate and (European) government bonds, with government bonds contributing to interest rate management at the long end of the curve.
Diversifies corporate bond investments across US dollar- and euro-denominated debt with a small allocation to emerging market debt. Corporate bonds are used to enhance yield and reduce the need for equities to generate portfolio return.
How JPMAM use a multi-asset approach to meet future cashflow needs
Over the past decade, UK pension schemes have engaged in a consistent programme of de-risking - moving from growth-focused portfolios to liability-driven investment strategies in a bid to reduce short-term balance sheet volatility. Yet, at a time when schemes are fast maturing, they are now facing a cashflow challenge. In response, J.P.Morgan Asset Management (JPMAM) have created a tailor-made, global multi-asset portfolio for a defined benefit pension scheme that seeks to de-risk while servicing material cash-flows. “Our recommendation,” says Sorca Kelly-Scholte, Head of EMEA Pensions Solutions & Advisory at JPMAM, “was to transition from a strategy where the assets are in aggregate funds, to a bespoke liability aware mandate.” JPMAM partnered with a German client with a mature defined benefit pension scheme that was looking to move away from an aggregate portfolio towards a holistic pension solution. The client’s primary objective was to de-risk the portfolio while ensuring the scheme’s assets were sufficiently cashflow-generative in order to meet pension payments. The client also needed to build an expected capital reserve in order to hedge against inflation and demographic risks.
“The scheme is now better hedged against interest rate movements while its investments generate a sufficient yield to reduce the risk that the scheme will become a forced seller of assets.” J.P. Morgan’s Pension Solutions and Advisory (PS&A) team, a specialist team of pension and capital market experts that sit within Institutional Strategy and Analytics, liaised with the scheme’s actuary to build a comprehensive view of the scheme liabilities. The PS&A team then worked with portfolio managers from our Multi-Asset Solutions and Global Fixed Income investment teams to build a portfolio solution that was asset-liability aware and cashflow generative. By working with portfolio managers, the PS&A team were able to ensure that the proposed solution accounted for market structure.
Sorca Kelly-Scholte explains: “The client has a well-funded scheme with a funding status between 110% and 120%, and scheme liabilities with a duration of 12.5 years. Liabilities have been partially transferred through an annuity asset to cover payments due to certain members of the scheme. The remaining scheme assets are invested, via a segregated account, in equities (30%), euro aggregate bonds (35%) and US aggregate bonds on a euro-hedged basis (35%).” She adds that the consequence of investing in aggregate bonds is a portfolio duration of 4.5 years, which means there is a large duration mismatch between assets and liabilities, and therefore a significant propensity for the pension plan’s funding status to be volatile. “To alleviate balance sheet risk, the client is looking for a holistic solution that better aligns scheme assets with liabilities. The scheme must service pension payments of 3%-4% of assets per annum. It also needs to ensure assets are invested in a cashflow generative manner so the scheme does not become a forced seller of assets while building a reserve against demographic and inflation risks.” After full analysis, JPMAM’s recommendation was to invest the scheme’s assets through a combination of equity funds and a liability-tailored buy-and-maintain fixed income sleeve. The bespoke nature of the buy-and-maintain portfolio yields a much closer liability hedge, resulting in a vast reduction of the previous duration mismatch.
How JPMAM build diversified CDI portfolios
Ensures the fixed income portfolio generates sufficient cashflows to meet outflows due over the next decade, reducing the risk that the pension plan is forced to sell assets during in-opportune periods to make pension payments.
2. Reduced equity exposure.
To meet the scheme’s requirements of reducing interest rate and forced-seller risk, and to build a reserve against risks that can’t be hedged, JPMAM:
The scheme’s assets have been chosen to ensure that they can
How JPMAM repositioned the portfolio to improve funding status volatility
Pension plan assets are better placed relative to the retained liabilities of the scheme while fixed income assets generate sufficient liquidity over the next decade to avoid the scheme needing to sell assets to make pension payments.
Reducing the asset-liability mismatch has a significant impact on the pension plan’s balance sheet stability, reducing surplus volatility significantly while offering the fund a larger expected return.
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Head of the EMEA Pensions Solutions & Advisory Group,
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J.P. Morgan Asset Management’s Pension Solutions and Advisory Group is a dedicated global team of actuarial, portfolio management and capital markets professionals focused on delivering product agnostic advisory services and implementable solutions though the pension lifecycle to clients. We work with product teams across J.P. Morgan Asset Management to ensure that our best proprietary investment thinking is reflected in asset allocation and asset liability management investment recommendations. For more information please visit www.jpmorgan.co.uk/institutional
Sorca Kelly-Scholte, managing director, is Head of the EMEA Pensions Solutions & Advisory Group. She is responsible for advising European institutional investors and leading strategic, proprietary research and thought leadership initiatives on pension investment issues. Sorca has 20 years of advisory experience, most recently at Russell Investments where she led strategic advice to advisory and fiduciary management clients in EMEA. Sorca has published extensively on pension, funding and investment issues. In particular, she co-authored Russell’s flagship ‘Fiduciary Handbook’ and lead authored of Russell’s institutional blog ‘the Wire’. Prior to Russell, Sorca was a senior asset consultant at Towers Perrin Forster & Crosby. Sorca began her career within the pensions advisory team at Coopers & Lybrand. She holds a BA (Mod) in Mathematics from Trinity College Dublin, and is a qualified actuary.
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