Robert Palmer discusses using a combination of cashflow driven investment and liability driven investment to buy some time for trustees.

Any pensions textbook (I'm probably showing my age here, it's bound to be "online learning" or "app driven" now) will profess in bold with italic script, possibly underlined in red, that defined benefit pension schemes are a long-term investment vehicle and should be treated as such.

This all seems fine until we leave the exam hall with a sense of relief and a pass mark tucked safely under our arm?hurrying back to the office to get back to the "real-world".

In my experience, the most far sighted of pension scheme sponsors seem to regard five year projections as a "long-term" plan.

This, together with accounting standards requiring annual reviews and most Trustees needing an annual funding update, means that short term fluctuation creates anxiety - leading to an investment strategy concentrating on managing the short term at the expense of the optimal long-term position.

From the employer's perspective, a stable contribution requirement is clearly more desirable than a volatile pattern of a similar value.

Liability Driven Investment has long been a practical tool available to all but the very smallest of schemes by helping to remove the volatility in results, and I believe that this will continue to play a significant role in managing pension scheme finances and investment.

However, as schemes mature they will tend towards a cashflow negative situation. This will be exacerbated by an increasing number (albeit minority) of schemes moving towards a fully funded status with reduced or nil contributions.

The obvious risk of a cashflow negative situation is that assets need to be realised at a "low point" in the market, effectively locking in investment losses.

This can be addressed by simply holding more cash, but there are smarter ways to solve this problem - I predict that schemes will increasingly be looking to restructure their portfolios and use assets to generate an income stream that is aligned with their precited benefit outgo. This can be achieved via a variety of means including the use of;

• traditional investment tools such as bonds and, possibly, property classes;

• investment products structured around infrastructure investments, which are expected to generate income over the longer term; and

• investment products whereby investment houses "create" bespoke cashflows within a unitised investment vehicle.

I believe that the increased use of Cashflow Driven Investment will buy Trustees some time, having put the short term "to bed" and letting them turn their attention towards the longer term. Liability Driven Investment can manage interest rate and inflation rate risk, whereas Cashflow Driven Investment can deal with the short to medium term requirements.

This combination provides the "breathing space" for residual assets to be invested over a longer time horizon. This should provide the time for the "equity bet" to come good.

Written by Robert Palmer, Partner at Quantum Advisory