Most institutional investors like defined benefit (DB) pension funds have liabilities as well as assets. Assets are the things that the institution owns, like bonds, equities and real estate. Liabilities are what the institution is obliged to pay out, like pensions to members of the pension fund or insurance polices to customers of the insurance company.
Matching describes a strategy for controlling risk that seeks to align the assets with the liabilities. This can mean one of two things: cash flow matching or value matching.
In this post we’ll explore cash flow matching; we’ll look at value matching next time.
What is cash flow matching?
Cash flow matching is when the payments into the institution’s investments line up with the payments out.
Cash flow matching is something that most of us experience day to day. On the asset side, we may have a job that pays a predictable salary each month. We also have plenty of liabilities that require regular payments. These may include mortgage or rent payments, loan or credit card bills, childcare fees and other expenses.
Life is a little more straightforward if our income looks at least somewhat like our monthly expenses. If our income is consistently much lower than our monthly expenses or very lumpy, then we need to decide how to make up the difference month to month. This could be by either dipping into our savings or from borrowing (e.g. an overdraft).
If our income is a lot more than our expenses in a month, then we need to choose where to park the spare cash. Do we move it into our longer-term savings. Or do we leave it in our bank account to meet future expenses?
Managing an institution is no different. Consistent, large mismatches between income and expenditure creates a headache for administrators and trustees. Apart for the administrative burden, investments may need to be sold, possibly at an unfavourable time.
A simple example
Here’s a simple example of cash flow matching in practice.
Imagine that an institution knows it needs to make a payment of £1 million, in exactly one year’s time. If it holds a single bond, with one remaining payment of £1 million, in exactly one year’s time, then as long as the bond issuer doesn’t default, it will have perfectly cash flow matched its assets (the bond) to its liabilities (the £1 million it needs to pay out). The institution will receive exactly £1 million from the bond, at precisely the time it needs it to pay its £1 million liability.
Cash flow matching and return certainty
Another benefit of cash flow matching is that it gives institutions greater return certainty. If an institution is consistently receiving cash from its investments earlier than it needs it, then it needs to reinvest that cash at an unknown rate of return.
If then, for example, interest rates fall in the meantime, the institution may not have as much cash as it needs when it’s time to eventually make payments. This is known as re-investment risk and it exists even when investing in very secure assets like government bonds.
How do DB pension funds cash flow match?
The pension fund first needs to understand the future cash flows from both its assets and its liabilities.
Examples of payments into a pension fund include coupons and maturity proceeds from bonds and payments from the pension fund’s sponsor.
The payments out of the fund are mainly payments to members (pensions etc.). They can also include the expenses of running the fund.
Liability cash flow forecasting
Cash flow matching begins with a very detailed picture of the liabilities. In the case of DB pension funds, this means forecasting the cash flows that will be paid from the pension fund over many years.
This is a huge calculation. Fortunately, the same cash flow picture is normally used for cash flow matching, ALMs (discussed in this post) and for actuarial valuations for funding1 and accounting, so the exercise only needs to be done about once every three years.
To build the picture of the cash flows, actuaries will first forecast the cash flows for each member of the pension fund – possibly tens of thousands of individuals. They then aggregate these across the whole pension fund.
A typical pension fund may have cash flows that look like the chart below. Each bar in the chart is the total amount the pension fund expects to pay out, across all its members, in a single year.
You might wonder how reliable this picture really is. After all, the pension payments to any one member will depend on when they retire, whether they have a spouse who will receive a proportion of their pension when they die and, most importantly, how long they will live, all of which are unknown.
In fact, it’s possible to build a pretty good estimate for the pension fund by using characteristics of the general population and applying these to the fund’s actual members. Although any one individual may outlive the average, or die earlier, these member-by-member variations should cancel each other out when the pension fund is considered as a whole.
Selecting assets to provide cash flow
Once the pension fund has a picture of its liabilities’ cash flows, it can choose assets to match these.
Matching assets need to have reliable and predictable payments. Government bonds or corporate bonds with higher credit ratings are natural choices. If the bond issuer doesn’t default, the bonds will deliver a predictable stream of coupons and final repayments at maturity.
Real estate may also be included if the properties have tenants that have signed up to long leases. These can provide a long, predictable (and inflation-linked) stream of rental payments.
Combining matching assets
The investment manager then begins to construct a matching portfolio by pairing up assets to the pension fund’s cash flows, usually beginning with those the furthest away. Other assets are then layered on, one by one, until all the liability cashflows are paired up to asset cash flows.
There are usually a few limitations though. Firstly, notice how, in the chart above, the last payment isn’t projected to be until after 21002. There are very few assets available that will make payments that far into the future.
Also, the assets that pay the most reliable and predictable payments will also have the lowest return. This is fine for DB pension funds in a strong financial position. However, if there is a gap between the assets and liabilities that needs to be filled, the pension fund will want to hold onto some assets like equities, that have higher forecasted returns, but less predictable payments, which wouldn’t be suitable for a cash flow matching strategy.
For these reasons, most pension funds will not cash flow match every payment. Instead, they may focus on only the first 10- or 20-years’ payments, building up a match of later payments when it’s affordable to do so, and/or when new assets become available that can match some of their longer cash flows.
They may also use leveraged strategies like liability driven investing (LDI). We’ll return to LDI, alongside value matching in the next couple of posts.
Image source: Pixels
- The triennial exercise where the pension fund’s actuary determines if the fund has enough assets to meet it’s liabilities. ↩︎
- This accounts for some members potentially living a very long time – until over 100, and because some pension funds will pay pensions to the children of members if both parents die before the child reaches adulthood. ↩︎
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