RETURN

1 CASE STUDY:

TRADITIONAL CDI ASSET SOLUTION

Typically, mature UK pension schemes invest in real CDI asset solutions in a progressive way, focusing first on the earlier liability cash flows (up to 10 or 15 years) and extending the level of matching over time to later ones.

Pension schemes often liquidate growth asset allocations first (and in particular listed equities) to fund their CDI investments. Allocations to liquid matching (LDI) assets are usually maintained, especially for long maturities, as these are more difficult to find in the universe of real CDI assets. The CDI portfolio versus the expected cashflows chart attempts to illustrate this concept by showing the endgame for such a strategy. The assets are then split between CDI (covering the first 15 years) and LDI assets as well as cash for collateral and benefit payment purposes (covering the rest of the cashflows).

Alongside the matching of cashflows by a holistic approach, the risk / return profile of a real CDI asset solution is, in most cases, tightly controlled and aims to fund the deficit over a number of years, complementing the sponsor contribution schedule and any remaining investments in growths assets.

In that context, our case study relies on a set of pre-defined objectives / assumptions that best illustrate a progressive and risk-controlled real CDI asset strategy that mostly focuses on matching the liabilities with shorter maturities.

  • Creates an illiquid asset portfolio that “matches” 60% of the liability cash flows for the first ten years
  • Maintains a strict risk budget with steady incremental upside and low volatility:
    • Target net excess return on GBP cash is 2.7%;
    • With a volatility of c. 3.6%

For real CDI asset solutions, portfolio construction guidelines are in general relatively well established and encompass the following:

  • Benchmarking the CDI portfolio against the liabilities of a typical UK pension scheme (in our case study, we have made the additional assumption that the income produced by the CDI asset portfolio represents about 15% of the liability cashflow);
  • Identifying the most appropriate CDI asset classes to achieve the required liability cash flow matching (see table on right for the risk / return assumption for each asset class); and
  • Maintaining an attractive risk / return trade off at portfolio level

In practice, we tend to only retain specific real CDI asset classes that best match the pension scheme’s requirements and investment guidelines as described above. For this case study, we have selected five of them:

  • GBP Commercial Real Estate Debt
  • GBP ABS
  • GBP Infrastructure Debt
  • Euro Mortgages
  • Euro Leveraged Loans

Illustrative metrics for the selected real CDI asset classes summarised:

  GBP-hedged return Volatility Maturities estimated
GBP Infrastructure Debt 3.4% 3.5% 8
GBP Comm Real Estate Debt 3.4% 3.0% 5
GBP ABS 2.5% 5.0% 4
Euro Mortgages 2.3% 5.3% 8
Euro Leveraged Loans 5.0% 7.8% 5
Cash 1.0% 1.1% -

BNPP AM, June 2020

No assurance can be given that any forecast, target or opinion will materialise.

Real CDI asset portfolio:
GBP infrastructure debt 40%
GBP commercial debt 10%
GBP ABS 10%
Euro mortgages 10%
Euro leveraged loans 30%
Portfolio metrics:
Return 3.7%
Excess over cash 2.7%
Risk 3.6%
Sharp 0.75
Coverage CDI first 10 years Liabilities 60.0%
Weighted average life CDI assets 6.4

The resultant real CDI asset portfolio is diversified and offers the modelled expected return and cashflow matching features. It is also worth noting that this optimal portfolio includes some currency exposure (to Euro) for Mortgages and Leveraged Loans and is hedged to Sterling.

The real CDI asset portfolio metrics are summarised. It is important to point out that the Sharp ratio is relatively low in a passive implementation modelling exercise. We would expect it to improve in an actual implementation context, which would be dynamic and would include added value from BNPP AM's fundamental views.

BNPP AM, June 2020

As funding levels improve and volatility in capital markets increases, pension schemes targeting self-sufficiency are thus able to implement a CDI portfolio strategy that can:

  • Improve the funding level of the scheme (through the enhanced discount rate levels associated with such portfolios);
  • Significantly lower the funding volatility; and
  • Reduce the ongoing reliance on the scheme sponsor.