CDI vs LDI – can you have your cake and eat it too?
The impact of COVID-19 means pension scheme funding levels have fallen, covenants have deteriorated, and liquidity requirements have increased. So, schemes need return, risk management and cash more than ever.
The impact of COVID-19 means pension scheme funding levels have fallen, covenants have deteriorated, and liquidity requirements have increased. So, schemes need return, risk management and cash more than ever. Some investment strategies force trustees to choose between these competing needs. But meeting cashflow, return and risk objectives needn’t be an either-or decision. In fact, combining segregated LDI with CDI is available today, irrespective of client size; as simply smarter investment solutions.
The last few months have thrown a spotlight on risk management strategies for defined benefit pension schemes. This follows an extended period of market volatility and unprecedented monetary and fiscal stimulus from central banks around the world. In the UK, schemes without high levels of liability hedging (“LDI”) will have seen their estimated deficits widen materially as long-term bond yields fell by 0.7% over the year to 19 June 20201.
As we look forward from here, sponsoring employers are under strain through lockdown. Recent research indicated as many as 1 in 5 Sponsors could suspend deficit reduction payments2. As highlighted in The Pensions Regulator’s COVID-19 guidance, it’s a crucial time for trustees to take a step back and revisit their cashflow management policy. Trustees should consider where they are sourcing their cashflow needs as liquidity will be challenging going forward.
There is, therefore, an increasing focus on cashflow driven investing (“CDI”). This approach requires schemes to allocate assets to strategies that will distribute regular income to support pension scheme cashflows. This can be invaluable to support trustees cashflow management.
But this can pose the following challenge:
- Do you fund a CDI allocation from Growth Assets? This will reduce the expected return from scheme assets at a time when funding levels may have been blown off track
- Do you fund a CDI allocation from LDI assets? If using a pooled LDI approach, this will reduce the level of liability hedging in place and you essentially reduce one risk (meeting cashflows) while introducing another (interest rate risk).
At R&M, trustees don’t have this challenge as we use segregated LDI across all clients, irrespective of size. This means trustees don’t have to make a choice. The liability hedge level can be maintained whilst improving the level of cashflow matching and the growth assets can remain to get you back on track.
We show this in the graphic below, depicting the LDI portfolio for an example client. By combining different asset classes, we can achieve the target hedging level and manage risk holistically.
Source: River and Mercantile, for illustration purposes only.
This has three distinctive advantage over traditional approaches:
- You can maintain higher hedging levels whilst explicitly matching your cashflow,
- You can build the hedge around CDI assets improving your portfolio efficiency as depicted in the chart above,
- You can maintain your target return to drive funding progress. So, in conclusion, at R&M you can have your cake and eat it too.
If you would like to know more about how we are helping trustees manage their key risks through uncertain times, then please contact us.
“As highlighted in The Pensions Regulator’s COVID-19 guidance, it’s a crucial time for trustees to take a step back and revisit their cashflow management policy. Trustees should consider where they are sourcing their cashflow needs as liquidity will be challenging going forward.”
1 - Source: River and Mercantile, 19 June 2020
2 - Source: https://www.isio.com/news-opinion/opinion-suspending-deficit-contributions/
This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that all material within this communication is produced by River and Mercantile Solutions and is directed at, and intended for, the consideration of Professional clients only. This document constitutes a financial promotion within the meaning of the Financial Services and Markets Act 2000 ("FSMA"). Retail clients must not place any reliance upon the contents.
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