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Three ways to manage the impact of cash flows on DB pension schemes

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Simon Hubbard takes us through the key points to consider when monitoring and managing a negative cashflow position.

Many DB pension schemes now find themselves in a negative cash flow position, where the contributions they receive from sponsors and members are less than their immediate outgoings for benefit payments. Consistently, the main reasons for this are because:

(i)  Many schemes have closed to future accrual;
(ii) Funding levels have improved, such that some
schemes are no longer receiving deficit repair
contributions; and
(iii) Pension freedoms have seen more transfers out of DB schemes in recent years.

How then can schemes monitor and manage this transition in their cashflow position, as well as the impact it has on the everyday management of the scheme? It’s important to look at the issue from three areas:

1.   Actuarial
The increase in transfer payments has created peaks in short-term cash flows for schemes. Although these will not generally create a strain on the funding level because trustees tend to set their transfer value basis below the level of scheme funding, there is a changing trend to be considered. Around 80% of the transfer values we paid in 2018 were to members aged over 55, so trustees should consider reviewing their transfer value basis to make sure transfer values in this age band are set appropriately.

Since The Pensions Regulator wrote to a number of pension schemes earlier this year with concerns about transfer values being too high, trustees should be making sure transfer values represent no more than the best estimate of the value of the member’s benefits (unless the scheme is very well funded) - and should also consider reducing transfer values if their scheme does not have enough assets to pay full transfer values to all members. For most schemes it’s tricky to model expected future transfer values because of their “lumpy” nature, as we know there will be transfer values paid out, but we don’t know when or how large they will be. It’s the few very large transfers that make cash flow management tricky and these will often be difficult to predict.

2.   Administration
We have seen a trend forming of deferred members transferring out prior to retirement in order to access their pension savings flexibly since the freedoms were introduced; this is now extending to members at retirement.
Increasingly pension scheme trustees want to offer members additional choices at retirement, not just the traditional retirement lump sum and pension. There are a range of alternatives that trustees are considering, from the standard pension and cash options at retirement through to quoting transfer options and making members aware of increased flexibilities. More schemes are now providing a full transfer quotation alongside the traditional retirement quotations and this array of options for members can make it harder to model the choices people are likely to make and therefore the immediate cashflow requirements.

3.   Investment
Most pension schemes no longer receive sufficiently large contributions and do not hold big enough cash reserves to pay pensions and transfer values of the size we are now seeing quite regularly. That means trustees need to think about their income needs in greater detail.

This boils down to two key issues:
(i)              How to deal with short-term cash flow needs; and
(ii)             How to effectively plan for future longer-term cash flow requirements.

Whilst it is difficult to plan for transfer value payments, trustees should consider retaining some liquid assets to meet potential payments. In addition, the possible impact of any large transfer payments distorting the cash flow profile of the scheme will need to be analysed, particularly where there is an existing Liability Driven Investment (“LDI”) strategy. For both short- and long-term income needs, Cash flow Driven Investment (“CDI”) strategies can certainly help, perhaps alongside growth assets and LDI to help close any funding gap.

CDI strategies can focus on both short-term expected cash flows and the longer-term income needs of a scheme, as well as offering greater certainty of return compared to a traditional growth portfolio. Whilst the solution may sound complex, it can actually provide trustees with a cost-effective, low-governance solution to both short- and longer-term income needs.

There are a number of issues to consider, so it is vital that schemes work closely with all of their advisers to build a strategy that works best for the scheme. A clear understanding of the interaction between cash flow management and the overarching investment strategy is key, as well as the planning of transfer communications to members and the value basis being set. Most importantly, these flags all need to be continually monitored, rather than simply assessed at a point in time.

Simon Hubbard, Senior Consultant and Actuary at Quantum Advisory.