Updated August 2023 – 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. This is “negative cash flow” and it presents unique challenges.
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”.
Selling risk is especially detrimental in declining markets, particularly for plans with high allocations to illiquid investments. This is because cash is typically raised through the sale of liquid assets, while illiquid assets generally exhibit lower price volatility than their liquid counterparts. This dynamic can swiftly lead plans to stray from their strategic asset allocations. Moreover, the necessity to liquidate assets in such downturns not only results in realized losses but also leaves the plan with fewer shares for potential rebounds, often culminating in longer-term underperformance.
Generally, greater asset price volatility is harder to bear for plans with negative cash flow vs. plans with positive cash flow.
Navigating the Tide: 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 serve as a beacon for mitigating investment risks, especially during pressing times when assets must be sold, even in an underperforming market. Unfortunately, many plans operating with a negative cash flow are set on “auto-pilot,” raising cash on a monthly basis without the due diligence or strategy it demands. Properly overseeing such pension plans isn’t just about routine monitoring; it necessitates a thoughtful approach to ensure optimal outcomes. Partnering with Agilis for investment consulting can provide the expertise and guidance needed to navigate challengings effectively, helping pension plans remain resilient and robust amidst the ebb and flow of market dynamics.