CASHFLOW NEGATIVE? DON’T IGNORE IT!

We were interested in the comments from PSolve “Cashflow Negative? Don’t worry about it!”

Whilst we appreciate the sentiment – and that might be the right advice in many circumstances – don’t forget that as benefit payments start to grow a dangerous black hole awaits.

We believe that Trustees ignore cashflows at their peril!

Why is this?
For younger pension schemes you can make an argument for behaving as a long-term investor. Rather like a turbine generating energy from waves, a pension scheme can ride out asset volatility, hopefully generating excess returns. This comes with risks of course but that’s for another conversation.

What’s important here is that the argument falls flat as a scheme matures and starts to pay out a big proportion of the fund in pension benefits. In particular, paying benefits in full from an underfunded scheme can send the scheme into a spiral that it simply cannot escape. You are paying out more than you can afford and the remaining assets have to work doubly hard to recover. Living outside your means can quickly spiral out of control – or send you running to the Sponsor for help.

In the chart we show the ‘stand still’ return that a scheme needs to earn. This is the return in excess of the valuation discount rate that you need to earn just to maintain a stable funding level. You can think of these as annual returns but it will work over any period. And indeed it can be instructive to replace the proportion of liabilities with a time horizon for your scheme.

Notice that with low cashflows (or 100% funding level) you just need to earn the discount rate to maintain a constant funding level – but as the benefit payments increase so your ability to recover from periods of under-performance declines. If you are only 80% funded and pay out 20% of the liabilities then you need to earn the discount rate plus 7% over the period just to stand still. Fail to earn that return and a falling funding level and increasing maturity will send the target return soaring.

Does this insight change the conclusions? Might it make sense to hold short dated assets that can be used to meet the benefit payments? Perhaps this gives the return seeking assets ‘room’ to perform over a cycle, or acts as a natural brake against taking too much risk?

We believe that understanding the maturity profile of your scheme – and how this is projected to change over the coming years – play an important part in setting a suitable funding and investment strategy.

So, is negative cashflow something that you should worry about?

Financial Canvas provides browser based dashboards tailored to the information that you want to see. Contact us today for this information for your scheme.

info@financialcanvas.co.uk