{"id":554,"date":"2019-11-07T08:00:58","date_gmt":"2019-11-07T08:00:58","guid":{"rendered":"http:\/\/www.cambridgeassociates.com\/insight\/pension-schemes-in-pursuit-of-income-growth-and-diversification\/"},"modified":"2023-10-23T22:46:26","modified_gmt":"2023-10-24T02:46:26","slug":"pension-schemes-in-pursuit-of-income-growth-and-diversification","status":"publish","type":"post","link":"https:\/\/www.cambridgeassociates.com\/insight\/pension-schemes-in-pursuit-of-income-growth-and-diversification\/","title":{"rendered":"Pension Schemes in Pursuit of Income, Growth, and Diversification"},"content":{"rendered":"

The UK Defined Benefit Pension Scheme universe is maturing, as more and more schemes have closed to future accrual (Figure 1<\/strong>). Funding levels have also generally improved over the past decade, aided by strong returns from growth assets and some liability hedging, which means sponsor contributions have fallen. We anticipate that many schemes are either cashflow negative or will be moving to a cashflow negative position very soon.<\/span> 1<\/a><\/sup> This will continue to cause problems in the current low-yield environment, where income is scarce.<\/p>\n

FIGURE 1 PROPORTION OF UK DEFINED BENEFIT SCHEMES CLOSED TO FUTURE ACCRUAL\u00a0<\/strong>
\n2008\u201318 \u2022 Percentage (%)<\/p>\n

\"FIGURE<\/a><\/p>\n

\n

Source: Pension Protection Fund, The Purple Book, 2018.<\/p>\n<\/div>\n

<\/div>\n

Although schemes might be closing their Technical Provisions funding gaps, they still have a long way to go before reaching their secondary funding targets such as buy-out or self-sufficiency. Data from the PPF indicate that aggregate funding levels on a buy-out basis have increased from 60% to 73% over the ten-year period that ended in 2018. This means there is still a significant need for growth above liabilities, which presents its own challenge, given valuations are stretched and global economic conditions have weakened. We believe a new approach, which is more flexible and accesses compelling investment opportunities, can help trustees.<\/p>\n

What is the industry doing to solve its current challenges?<\/h3>\n

In response to the income problem, many trustees are considering cashflow-driven investment (CDI) strategies. Such strategies rely on income from sovereign and corporate credit as well as on high-accuracy cashflow modeling to match benefit payments with income. While this may be appropriate for mature schemes with more predictable cashflows, we question whether these strategies are over-engineered. In other words, could CDI ultimately constrain trustees\u2019 ability to meet their required return by relying too much on yield generation from a narrow set of strategies and assets?<\/p>\n

\"\"<\/a><\/p>\n

A new approach to dealing with the issues faced by schemes today<\/h3>\n

A traditional approach to pension investment segregates the portfolio into return-seeking and matching buckets and then tries to incorporate liability-driven investment (LDI) and CDI within the matching bucket. We believe this may prove ineffective over the longer-term, especially given the problems highlighted earlier. Trustees should therefore consider an alternative \u2018universal\u2019 approach, which provides more flexibility, increases the drivers of income, and accesses more diversified risk premia.<\/p>\n

We believe this universal approach can help trustees generate sufficient income to exceed expected shorter-term cashflow needs so that there is less reliance on modeling accuracy.\u00a0 It also tolerates unexpected member experience, which can put pressure on liquidity. We achieve this by identifying managers that can deliver alpha above a market benchmark and by allocating capital to private investments that should allow schemes to access a premium above the public market (such as a diversifying private credit portfolio that includes real estate debt, royalties, leasing, and life settlements). Looking beyond traditional fixed income assets for income and return generation in the current environment is key if schemes want to be able to meet their objectives. And opportunities exist (Figure 2<\/strong>).<\/p>\n

FIGURE 2 YIELD CAN BE FOUND, BUT IT REQUIRES LOOKING BEYOND
\nTRADITIONAL FIXED INCOME ASSETS<\/strong>
\nTotal Returns (%)<\/p>\n

\"TRADITIONAL<\/a><\/p>\n

\n

Source: Cambridge Associates LLC.
\nNotes: ‘RTN’ are Cambridge Associates’ projected returns under the Return to Normal scenario in which model inputs are assumed to mean revert over a ten-year period. ‘Normal’ are based on Cambridge Associates’ long-term equilibrium assumptions.<\/p>\n<\/div>\n

<\/div>\n

A universal portfolio can make full use of all potential sources of income. This may increase schemes\u2019 ability to pay both planned and unplanned benefit payments, without needing the scheme to become a forced seller of growth assets. Considering income and growth sources holistically across the total portfolio means there is less reliance placed on one or two asset classes (or risk drivers) and can result in a truly diversified portfolio.<\/p>\n

This approach can help trustees continue to take advantage of the most attractive opportunities from a risk-return perspective, and access the illiquidity premium, even as the scheme de-risks. Simplistically, it relies on three key building blocks:<\/p>\n