We see cash flow matching strategies gaining traction among US and UK defined benefit (DB) pension plans—particularly those that are cash flow negative—due to their ability to balance short-term liquidity needs with longer-term investment objectives such as return generation.
- The rise of cash flow negative DB pension plans. A growing number of DB pension plans in the US and UK have annual benefit payments that exceed contributions received (Exhibit 1). For mature pension plans, entering this cash flow negative state is a trend that will continue and even accelerate in the coming years. As a result, funded ratios for underfunded plans will face downward pressure and may require higher returns to narrow their funding deficit.
- Plans are looking to make assets “work harder” irrespective of their cash flow status. Plans are increasingly seeking out return-generating assets that can narrow funding deficits and fund future benefit accruals. This is particularly true for US public DB plans, 72% funded in aggregate on a reported basis. Often such potentially higher-return investments are illiquid, forcing pension plans to consider the balance between short-term liabilities and long-term needs.
- Cash flow matching strategies can balance short-term liquidity needs with longer-term investment objectives. A cash flow matching strategy aligns short-dated liabilities with high quality liquid fixed income assets. This alignment allows plans to allocate more of their remaining funds in longer-dated assets that may have lower liquidity but higher return potential.
- Strict adherence to a pre-defined cash flow schedule. A cash flow matching strategy seeks to generate predictable income and principal cash flows with limited portfolio turnover. In effect, a cash flow matching portfolio will adopt a “buy and maintain” approach adhering to a pre-defined cash flow schedule, rather than a less-constrained active approach.