Majority of UK defined benefit plans are cash-flow negative
Almost three quarters of UK defined benefit plans are cash-flow negative, placing them in a precarious position amid a volatile geo-political and economic environment. According to a new study, sustainability and diversification drives are what is needed to shield assets from the increasingly unpredictable market.
The latest incarnation of Mercer’s Asset Allocation report has found that 73% of UK defined benefit plans are cashflow negative, up from 66% in 2018. This means that for three out of four defined benefit schemes, the amount of benefits paid out annually is higher than the amount of new contributions received. The key driver behind the year-on-year increase is the maturity of such plans, most of which are now being closed both to new members and new accrual of benefits.
According to the analysis, the news is symptomatic of a broader pan-European trend which will only accelerate in the coming years. A significantly higher proportion of plans were cash-flow negative at the time of the survey across the EU compared to last year’s study (64% versus 56% in 2018). Of the 36% of plans that remain cash-flow positive, 72% expect to become cashflow negative within the next 10 years.
Cash-flow negative DB plans require proper management in order to meet cash-flow and collateral needs. While the defined benefit industry might presently be riding high, Mercer’s researchers warn against complacency, which could have dire consequences in a rapidly shifting geo-political and economic landscape.
Jo Holden, UK Chief Investment Officer at Mercer, said, “While 2019 has so far been marked by cautious optimism, investors need to be very aware of an ever-evolving macro-economic and political backdrop. Mounting evidence of overextension of credit, possible liquidity implications as central banks rein in their market involvement, and continuing political fragmentation, all mean investors should consider effectively positioning their portfolios to weather possible market volatility.”
With volatility still proving the watch-word in 2019, Mercer’s report expects an increasing focus on sustainability, anticipating it will soon be seen as an integral part of investment idea generation and risk management. While 91% of surveyed schemes disinvested assets as a way to meet cash-flow requirements, sustainability is indeed gathering notable momentum among European institutional investors, with 55% now considering environmental, social and governance (ESG) risks in their schemes, up from 40% in 2018.
Of the funds taking a more proactive stance on ESG risks, 60% of those polled by Mercer cited regulatory pressures as the primary driver. Mercer expects this trend to keep strengthening as a result of the introduction of the 2017 European Pensions Directive, IORPII, and the UK’s Department of Work and Pensions Investment Regulations, which will come into force in October 2019. These regulations will require pension funds to take ESG factors such as climate change into account when making investment decisions.
Diversity
At the same time, Mercer’s research also found that diversification is being used as a method of insulating assets against risks. Late in 2018, another Mercer study revealed that 37% of pension schemes are currently enjoying a funding surplus. At the same time, however, a similar number are yet to agree on a long-term target for their funds, suggesting they could be doing more to capitalise on their current momentum.
What is clear now, however, is that investors have continued to look for ways to diversify their strategies away from equity exposure, following 10 years of strong equity returns, with the average equity holding falling from 28% last year to 25% this year. Mercer’s study suggested on this basis that investors have increased their allocations to real assets in the search for diversification as well as cash-flows, seeing as the number of plans with an allocation to real assets and hedge funds increased by 4% and 6%, respectively, over the year.
Matt Scott, Investment Consultant at Mercer, remarked, “Strong equity returns in 2017 and rising yields in 2018 have helped many DB plans to move closer to their endgame. Investors should consider developing a strategy to meet cash-flows, to avoid relying solely on disinvestment which can be complex and expensive. We believe that cash-flow matching techniques, where portfolios are specifically designed to align income and principal receipts, will be more widely adopted in the coming years, as defined benefit plans continue to mature.”
