Pension Investing: How to Invest When Cash Flow is Negative

As baby boomers retire, many pension plans are reaching a point where the amount of money leaving the plan in benefit payments and fees exceeds the sum of incoming contributions and investment income.  This is “negative cash flow” and it presents different challenges for an investment committee to consider versus when cash flow was positive.

Once the plan is in a state of negative cash flow, the risk inherent in managing assets changes.  For a plan with positive cash flows, the asset manager needs to decide where to invest income and contributions – this is “reinvestment risk”. Conversely, a plan with negative cash flows must raise cash regularly to pay benefits by selling assets, which we term “sell risk”.

Sell risk becomes most detrimental in periods of declining markets and can be more pronounced for plans that have relatively high allocations to illiquid investments because cash will most likely be raised through the sale of the liquid assets. In addition, illiquid assets often have lower price volatility than liquid assets which can quickly cause plans to deviate from their strategic asset allocations.

The issues become pronounced when needing to sell assets in down markets which creates realized losses and leaves the plan with fewer shares invested when markets rebound, typically leading to longer-term underperformance.

Generally, greater asset price volatility is harder to bear for plans with negative cash flow vs. plans with positive cash flow.

The following are best practices for pension plans with negative cash flows:

• Higher cash flow investments – Given the choice between two investments that will have similar expected long-term returns and risk, choose the one that produces more income vs. capital appreciation.  This may mean choosing more dividend-paying stocks or choosing to hold more private debt vs. private equity, etc. 
• Improve investment risk management – higher asset price volatility = higher probability that assets will be sold when down. Consider ways to reduce asset price volatility while not impairing liquidity.
• Contribution policy – Make contributions more frequently. Monthly contributions will help reduce the amount of asset sales needed rather than annual or quarterly contributions.
• Enhance governance– Ensure the plan’s investment policies allow for a degree of tactical decision-making on the part of the investment managers. As cash needs to be raised frequently, allowing the manager overseeing asset allocation to raise cash tactically, even if only a few days or weeks early when market returns are strong, should improve returns.

These best practices can reduce investment risk that arises with the need to sell assets on a regular basis, even when markets are struggling.  Many plans with negative cash flow are on “auto-pilot” and raise cash monthly without much thought or care.  Properly overseeing pension plans with negative cash flow positions requires close monitoring and thoughtfulness to produce optimal outcomes.

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