Is CDI the new LDI, or the new DGF?
Every so often a new product or idea becomes a buzzword (or three letter acronym!) in the pensions industry. But there is a risk that trustees are 'sold' the latest product by fund managers and consultants, rather than consulted.
Some solutions, such as hedging unrewarded interest rate and inflation risk through Liability Driven Investment ("LDI"), are applicable to almost all pension schemes, but our experience shows that others are only suitable for particular clients. Diversified Growth Funds ("DGF's") are a prime example. Although these 'off the shelf' products can be a good source of diversification for trustees with low governance budgets, we have long acknowledged their drawbacks (Do DGFs solve the diversification problem?)
So, which camp is CDI in?
The rationale behind CDI is that trustees can replace their existing return-seeking allocations with a carefully designed portfolio of income-generating assets which are expected to provide the income to pay pensions and expenses as they fall due.
"Income is better than capital appreciation"
There are two benefits to income, assuming a scheme's outflows are bigger than its contributions:
"Risk of being a forced seller"
If markets crash, it may be a bad time to disinvest from the scheme's assets to meet cashflows. With an income-generating asset, the capital value can fall but it can still meet the scheme's cashflows if it continues to generate the required income (this assumes that these assets, which are often credit-based, don't default of course.)
"What if we change the discount rate to mirror the expected income from the assets?"
The argument is as follows: if the assets of the scheme are invested in a portfolio which is expected to meet the scheme's cashflows over time, the discount rate be can set with reference to the return on those assets. This might improve the funding level on the Technical Provisions basis, and lead to greater funding level stability.
There are many pros and cons of this approach, and it may not be suitable for all schemes (see Funding DB pension schemes – Getting the numbers right).
CDI may be the correct strategy for you. If your scheme is:
However, it's not appropriate for all schemes. It may not be suitable if:
Regardless of the appropriateness of CDI for your scheme, having a cashflow management strategy is key. We believe that trustees should consider:
Watch out for future posts which cover these points in more detail. In the interim, if you are interested in assessing or improving your scheme's cashflow management strategy, please speak to your consultant.
With thanks to Gareth Jones as co-author.
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