Pension funds cannot afford to use short-term fixes when they begin to turn cash flow negative as this could “crystallize or exacerbate” funding shortfalls, UBS has warned.
“The methods employed for dealing with [negative cash flows] can actually crystallize or exacerbate any existing funding gap.” —UBSIn its annual “Pension Fund Indicators” report, the group analyzed how UK pensions—particularly those closed to future accruals—were dealing with the surge in members reaching retirement age. Gavin Lewis, executive director for institutional business development, Ben Lloyd, head of UK marketing, and Joshua McCallum, head of fixed income economics, wrote this section of the report.
“Pension funds have found themselves becoming cash flow negative just as increasing numbers of members have begun to retire, placing greater demands on the need for cash,” the UBS staff wrote. “Some pensions have recognised this trend, but the methods employed for dealing with this issue can actually crystallize or exacerbate any existing funding gap.”
By relying on a cash balance within a portfolio, Lewis, Lloyd, and McCallum warned that pensions risk creating a large pool of low-yielding assets that drag on overall returns. The bank said some funds had allocated between 5% and 10% to cash to meet payments to pensioners.
Selling assets to meet cash requirements is just as challenging, the trio added.
“Evidence suggests that some schemes may be tempted to sell assets, particularly equities due to their more liquid nature,” the report said. “But this brings with it a number of challenges, not least from a governance perspective: what assets to sell, when to sell them, and who is responsible for considering the longer term implications.”
The equity market rally of recent years “may also give a false sense of security”, the authors warned. The S&P 500 hit its latest all-time high close of 2,130.82 on May 21 this year, and closed at 2,126.64 on July 17. The FTSE All-Share reached a five-year high of 3834.45 in April but had fallen by more than 8% from this level by July 7.
“It has been easy to determine something to sell in an environment of sharply rising asset prices but it may prove more challenging to determine something to sell when asset prices are falling sharply,” UBS said.
Even a liability-driven investing approach may be insufficient on its own, the report said, as the assets involved were typically long term and illiquid rather than income-producing.
Lewis, Lloyd, and McCallum said solutions for pensions that are turning to a “cash flow negative” outlook would not be single asset classes.
“Characteristics such as whether the scheme is open or closed, the size of its governance budget, and whether it is in deficit or fully funded will likely influence how the scheme prioritises meeting long-term liabilities, generating growth, and achieving positive cash flows,” the report said.
UBS’ full report can be accessed online.
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