Anton Wouters, Head of Solutions and Client Advisory in Multi Asset, Quantitative & Solutions, and Maurice Kraaijenbrink, Senior Solutions Designer in Multi Asset, Quantitative & Solutions, explain the cash flow driven investment (CDI) concept.
What is new in the CDI concept is that a CDI portfolio is added to a pension fund’s matching portfolio. The traditional liability-driven investment (LDI) portfolio as part of the matching portfolio continues to exist; it serves to cover long-term pension liabilities. The same applies to the return portfolio, which focuses on additional returns. In the LDI portfolio, government bonds also form the collateral for the use of derivatives.
Wouters: “This means the LDI and CDI portfolios together form the new matching portfolio. The LDI portfolio primarily hedges the duration risk and the CDI portfolio primarily hedges the cash flow risk (see exhibit 1).”
Exhibit 1: How can LDI and CDI be combined?
Source : BNP Paribas Asset Management, data as of February 2018
The CDI concept has evolved from the current situation where pension funds are confronted with a low interest rate and a low funding ratio. This has forced pension funds to consider new ways in which they can extract value from investments.
Kraaijenbrink: “With a CDI portfolio of fixed-rate, but less liquid investments, a higher return can be achieved, while cash flows are generated that help cover the liabilities. Examples are less liquid asset classes such as mortgage loans, SME loans and infrastructure and commercial property loans. A CDI portfolio, which sits somewhere between LDI investments and the matching portfolio, has a number of advantages: additional return, stable cash flows, less volatility, diversification and inflation sensitivity due to the fact that a number of these investments are linked to LIBOR.”
Why did the CDI concept originate at British pension funds?
Wouters: “Many British pension funds are in a situation where they are underfunded and corporate sponsors, as the parties responsible for the pension funds, strive to make them fully funded within a specific period of time, so that they can sell the pension fund to an insurer in due course or can dispose of their liabilities in a different way. Moreover, British defined benefit (DB) pension funds are closed to new entrants – no new premiums are received – and have a clear, often negative cash flow, which makes them very suitable for a CDI approach.
“Another point is that in the UK, liabilities are valued on the basis of a prudent valuation method with the necessary degrees of freedom, including a link to the expected investment return. In this context, a CDI portfolio can lead to a lower valuation of the liabilities. This is another reason why CDI is quickly gaining ground there.”
Current price of shares and bonds
Kraaijenbrink: “It is also interesting to consider the price of shares and bonds. Now that yields are under pressure, a naive approach could be to invest more in shares. This would entail more volatility and would have an economic impact on your balance sheet, as well as an impact from a regulatory perspective. Some pension funds are not even allowed to do this given their current situation.
Another point: almost everyone says that fixed income is expensive, which is due to the low interest rates. But shares are not a cheap asset class at the moment either, given the generally sharply higher equity markets. How much more room for manoeuvre is left? This definitely applies to the US, where Dutch pension funds are still investing a large part of their equity portfolios. These could be extra arguments – in addition to the ones we mentioned earlier – for considering CDI.”
What is the impact of CDI on the volatility of the average portfolio of a pension fund or insurer?
Wouters: “We can show this on the basis of portfolios where we have operated very prudently. If you replace 10% of a typical pension fund portfolio (40% shares, 60% long-term fixed income) with CDI, you will not see a leap in the return, which remains the same or shows a slight rise, but you will see a drop in volatility. The same in fact applies to insurers, although they tend to invest less in shares. In the example of an insurer, we have focused on the solvency capital requirements; these are reduced when CDI is applied. This means CDI is also advantageous for insurers, in terms of both volatility and required capital.”
The funding ratio is an important factor in the calculation on the basis of which a CDI portfolio is allocated. Kraaijenbrink: “The wealthier a pension fund becomes, the more emphasis there will be on full or partial indexation, so the fund will slightly reduce risk and concentrate more on the cash flows. For example, for a Dutch pension fund with a nominal funding ratio of 135% or 140% (close to a 100% real funding ratio), it is better to replace equities with CDI. If, as a Dutch pension fund, you have a lower funding ratio, you will be more inclined to let the CDI portfolio pay for the fixed income part of the portfolio.”
What are the consequences of CDI for the liquidity of investment portfolios?
Kraaijenbrink: “CDI will be detrimental to the liquidity, but you will get the benefits mentioned earlier in terms of returns. It is important that you are able to deal with the reduced liquidity in your investment portfolio. Current liquidity is important in this respect, but what is perhaps even more important is what happens to future liquidity in five or 10 years’ time. This question is more difficult to answer, and we test this using simulations and stress tests. The average pension fund has to retain the necessary liquidity to be able to pay out the pensions, but also to pay for the costs and collateral of the derivatives portfolio.”
Wouters: “CDI is therefore not a stand-alone approach, but it forms part of a total balance sheet approach, in which we also look at cash management, derivatives management and collateral management.”
For which types of pension fund is CDI suitable?
Wouters: “In the Netherlands, CDI could be suitable for pension funds that still have premium income and may therefore accept some illiquid assets in the portfolio. For an older fund contemplating discontinuation within the next couple of years or transferring to an insurer, this would be less suitable given the mismatch between the investment horizon of the pension fund and the investment horizon typically linked to all or part of the CDI investments. We also think it would be more suitable for larger and medium-sized pension funds that have the in-house governance, capacity and knowledge to fully understand and monitor the CDI concept.”
Lower required capital for insurers
The longer-term stable cash flows with a higher coupon can also be attractive for insurers. Wouters: “A number of the asset classes in a CDI portfolio have been positively assessed for insurers in terms of capital. Investments in infrastructure or commercial property, for example, have a lower required capital ratio than corporate bonds with the same credit rating. On the other hand, specific asset classes also leave scope for a more sustainable implementation of the portfolio, for example, by including climate-neutral buildings in a property portfolio. I will come back to that later.”
How does CDI compare with the Dutch FAF?
Kraaijenbrink: “An essential question is: what is the impact of CDI on the required funding ratio of Dutch pension funds? The shift towards a CDI portfolio at the expense of equity exposure means a reduced equity-related risk of the return portfolio, but what is the net effect of this? Furthermore, the current FAF (Financial Assessment Framework), operates differently from that in the UK, with an official discount curve. Proper matching can only take place if there is sufficient correlation between the official discount curve and the CDI portfolio.”
Wouters: “This is less relevant in the British pension system. Due to greater flexibility in the choice of the discount curve, British pension funds can focus more on matching the liability rather than merely considering interest-rate sensitivity relative to an official discount curve. In the Netherlands, the FAF regime is not yet able to give all the answers to the situation with CDI assets and public demand for this type of investment. At BNP Paribas Asset Management, we believe that more research is required to get a better insight into the following questions: to what extent does the CDI concept fit into the Dutch regulatory framework, what is the best way to integrate CDI and which pension funds would benefit most from this?”
What does the future hold for CDI? Are there any trends in CDI?
Wouters: “A social discussion is taking place about the energy transition and making the private sector – along with the government and the taxpayer – contribute to infrastructure. This is actually already happening with regard to insurers, because of the reduced capital requirement, but this does not yet apply to the FAF, in which the statutory financial requirements imposed on pension funds are laid down.”
Kraaijenbrink: “In the asset classes in which CDI takes place you can, as a pension fund or insurer, give direction to the energy transition, for example, by encouraging climate-neutral buildings or by implementing your ESG (environmental, social and governance) objectives. This sustainability aspect can therefore also play a part in the choice by a pension fund or insurer of CDI, not in quantitative terms, but in the way in which you want to construct an investment portfolio.”
This article was previously published in Financial Investigator (edition 5).