All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
Defined benefit (DB) pension schemes have faced many challenges over the years, ranging from burgeoning liabilities to disappointing returns. Today, in a world also grappling with Covid-19 repercussions, many schemes face a new test. This latest issue is cash flow negativity, where schemes require more cash to pay pensions than they receive in contributions and investment income.
Historically, many pension plans have relied on selling assets to fund cash flow requirements. This can be expensive or risky, or both. Trading costs, sequencing risk1 and distortions caused by not being able to sell illiquid assets proportionately can all have an impact.
Understandably therefore, mature DB plans can be tempted to increase their allocation to higher yielding assets, such as bonds. On the surface this can seem an appealing route, particularly when these assets are wrapped up under the banner of ‘multi-asset credit’, which has a reassuring ring of diversification, or ‘contractual income’ that sounds almost like a guarantee. But, while multi-asset credit managers can aim to navigate the risks around corporate credit, emerging market debt and structured finance, and may even preserve capital by doing so, their figurative palette is somewhat limited. It can produce a high income and, defaults permitting, perhaps even sustain it. In isolation, however, multi-asset credit has no real prospect of achieving income growth. And if income doesn’t grow, it will be severely eroded by inflation over the long term.
To illustrate how severe this erosion can be, imagine a pension fund which will be paying out income to pensioners for the next 20 or 30 years, to meet entitlements which are largely inflation-linked. Let’s suppose that inflation stays at 2% a year. To keep up with it in 20 years’ time, the fund will need to be paying out £150 for every £100 it was paying out at the beginning. So, although they can be a useful boost to income, bonds cannot be the whole answer because they are not ordinarily an inflation-linked asset. What’s more, inflation-linked bonds are currently so expensive that they have negative yields, so they aren’t the solution either.
1. Sequencing risk - One of the challenges facing investors requiring regular income over a period is so-called ‘sequencing risk’, also known as ‘path dependency’. This risk stems from the unknown sequence of periodic investment returns that assets will deliver over time. If an investor relies on capital drawdown – the sale of assets to realise ‘income’ – the overall financial outcome can vary significantly. Financial assets do not generate returns in a linear fashion, and even if the same compound return is achieved in two different scenarios, the paths to that return are likely to vary considerably. If a series of poor returns is experienced in the early years, capital drawdown can crystallise losses and lead to significantly worse outcomes in the long term.
That’s why over the past four or five years there has been an increasing focus on assets such as infrastructure – or real assets as they’re often known. Whether it’s a private finance initiative (PFI) type asset, or one related to renewable energy or even toll roads, there is scope for an income that is both high and grows with inflation. An asset like that can certainly be part of the solution to generating solid income over the long term.
The question we would ask, as pension schemes plan for cash flow negativity, is why stop at infrastructure? That’s particularly pertinent because there are several other real assets that schemes can invest in to achieve inflation protection while generating a good level of income to help pay pensions. Property is perhaps the most obvious. It typically has some kind of inflation protection in it as well, because rental payments usually feature an annual increase, often in line with inflation. So, property can be another great asset to put into the mix.
Many sophisticated investors, however, are now contemplating the transformative step of investing in equities for income, of figuratively having all the colours on their income palette. That’s because equities have the potential to negate the effects of inflation over time, and to generate above average, inflation beating growth in income.
Not all equities can fulfil this role of course. For a start, many companies pay no dividends. Others have cut their dividends, which is rather unhelpful too and, as has been demonstrated by companies such as Shell in recent months, it is often the highest yielders which are most vulnerable in times of crisis. Many have poor growth prospects or face threats from competitors or regulators, or even the impact of climate change concerns. But there’s a sub-set of equities available to investors, let’s call it ‘dependable equity income’, which can pay strong and rising dividends that should beat inflation over time. These equities can be particularly helpful in meeting this challenge of providing a good income stream to pay pensions over the long term.
Returning to the broader challenge, the approach of looking across the full spectrum of income paying asset classes is typically called a multi-asset approach to income, or a multi-asset income strategy. The largest pension schemes can potentially put these building blocks in place themselves, but doing so requires a significant governance and research burden and ongoing responsibility for asset allocation and for income generation. An alternative is to invest in a fund which itself aims to provide a diversified, resilient and growing income stream by investing across the full opportunity set, and by being highly selective at the underlying security level. The latter is especially important in multi-asset income investing, because equity income is not contractual. And, as has been demonstrated by the property sector in recent months, even contractual income is only as good as whoever or whatever issuer, asset or tenant stands behind it.
But leaving the importance of individual asset selection to one side, it’s worth illustrating why such multi-asset approaches can be helpful, why they can work so well. At first glance the chart below looks incredibly complicated, but on closer inspection it is straightforward. It’s divided into four squares. Starting in the bottom left square, let’s call it ‘the quadrant of despair’, these are assets that today have a negative yield, negative income after inflation, and capital that is being eroded by inflation. So, assets such as developed market government bonds are in there.
Real Yield vs Real Capital Growth
In the top left quadrant are multi-asset credit asset classes, which at least give a positive yield after inflation, although capital is still being eroded over time and, as we have said, income will be too.
What we believe, based on our own modelling and long-term return expectations, is that, if you add infrastructure and property and the right type of equities into the mix, their inflation matching or beating characteristics should allow for a shift to the sunny uplands in the top right. In that quadrant, using a multi-asset income approach, schemes or managers could be generating about a 4% yield which, compared with cash and government bond rates, is very attractive. At the same time, both the income stream and capital value can keep ahead of inflation. If they can do that it would be a great place for schemes to be, as it would mean that they would be in a much stronger position to keep paying pensions, and to deal with cash flow negativity.
So that growth element, or matching of inflation, is a big part of the attraction of this way of investing for income. The second advantage of this approach is to do with diversification, particularly diversification of income. Indeed, it is the benefits of diversification which also help to overcome the traditional objection to including assets such as equities in an income-oriented approach; namely, that the income they produce can be quite volatile.
The chart below shows the most extreme drops in income of around 20% that we saw for infrastructure and equity through the Great Financial Crisis in 2008/09. So how does that fit with generating a nice, steady income stream to help pay pensions? By taking a multi-asset approach you are blending in those developed market government bonds, investment grade bonds – not so good in inflation terms, but fantastic at delivering a very resilient and reliable annual income stream. So, the modelling suggests that, by pairing those together with more volatile income streams, the result would have been that a multi-asset approach would have given a resilient and smooth income stream, particularly if emphasis is placed on income resilience when selecting stocks.
Maximum Income Decline
In fact, as the chart illustrates, even in the most extreme circumstances through the financial crisis, our modelling pointed towards a drop in income of only 10% or so in that year, this resilience being a benefit of diversification.
Of course, we are now in the midst of an even more extreme stress test and this year income from UK equities, for example, is expected to fall by over 40%. Reassuringly, our latest projection for our own Multi Asset Income Fund’s income for 2020 is that the drop in income will be limited to less than 10%.
The last benefit of this type of multi asset approach is the scope to add value. In relation to asset allocation, where there are several asset classes in the mix there’s the potential to do this by avoiding those that look particularly expensive and trying to favour the ones that look cheaper. This applies whether it’s trustees or investment committees and their consultants, or a specialist multi-asset income manager, seeking such opportunities. This flexibility is particularly important in times of uncertainty and volatility, when an asset class which is expensive or risky today could well be an attractive long-term proposition only a few weeks down the line. And such flexibility is not always available where schemes choose to invest directly in illiquid assets such as private debt, property and infrastructure.
As mentioned above, the scope to add value and increase resilience applies within asset classes too, and this is especially important in the realm of income investing, where individual companies, bond issuers, governments, properties and infrastructure projects can collectively pay a high and growing income stream to pensioners, although this is not the case for ex-growth, over-indebted companies, under-utilised assets, empty properties or neatly packaged and securitised toxic debts.
Charles Dickens wrote in Little Dorrit that credit is a system whereby "a person who can’t pay gets another person who can’t pay to guarantee that he can pay”. OK, so he was really writing about debt guarantors, but it does provide a useful reminder that a promise or obligation to pay income may not be worth the paper it is written on.
The comfort provided by credit ratings, contractual income or declared dividend policies may prove to be illusory, particularly in the current challenging environment. Diversification, on the other hand, genuinely reduces income risk. Together with selective and flexible investment, sensitive to price, focusing on the resilience and dependability of underlying cash flows, and incorporating an element of growth, it is the key to paying pensions over the long term.
The views expressed in this article are those of Anthony Dickson and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in September 2020 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.
All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.
The images used in this article are for illustrative purposes only.
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.
Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.
Persons resident or domiciled outside the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.
Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018 and is authorised by the Central Bank of Ireland. Through its MiFID passport, it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions ("FinIA"). It does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. It is the intention to ask for the authorisation by the Swiss Financial Market Supervisory Authority (FINMA) to maintain this representative office of a foreign asset manager of collective assets in Switzerland pursuant to the applicable transitional provisions of FinIA. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co.
Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 licence from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 can be contacted at Room 3009-3010, One International Finance Centre, 1 Harbour View Street, Central, Hong Kong. Telephone +852 3756 5700.
Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.
Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.
This material is provided on the basis that you are a wholesale client as defined within s761G of the Corporations Act 2001 (Cth). Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth). It is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 2001 (Cth) in respect of these financial services provided to Australian wholesale clients. Baillie Gifford Overseas Limited is authorised and regulated by the Financial Conduct Authority under UK laws which differ from those applicable in Australia.
Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.
Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.
The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission. Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.
Baillie Gifford Overseas Limited (“BGO”) neither has a registered business presence nor a representative office in Oman and does not undertake banking business or provide financial services in Oman. Consequently, BGO is not regulated by either the Central Bank of Oman or Oman’s Capital Market Authority. No authorization, licence or approval has been received from the Capital Market Authority of Oman or any other regulatory authority in Oman, to provide such advice or service within Oman. BGO does not solicit business in Oman and does not market, offer, sell or distribute any financial or investment products or services in Oman and no subscription to any securities, products or financial services may or will be consummated within Oman. The recipient of this document represents that it is a financial institution or a sophisticated investor (as described in Article 139 of the Executive Regulations of the Capital Market Law) and that its officers/employees have such experience in business and financial matters that they are capable of evaluating the merits and risks of investments.
This strategy is only being offered to a limited number of investors who are willing and able to conduct an independent investigation of the risks involved. This does not constitute an offer to the public and is for the use only of the named addressee and should not be given or shown to any other person (other than employees, agents, or consultants in connection with the addressee’s consideration thereof). Baillie Gifford Overseas Limited has not been and will not be registered with Qatar Central Bank or under any laws of the State of Qatar. No transactions will be concluded in your jurisdiction and any inquiries regarding the strategy should be made to Baillie Gifford.
Baillie Gifford Overseas is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755-1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This document is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.
48747 PRO AR 0100
Anthony joined Baillie Gifford in 2001 and is a Director in the Clients Department with responsibility for UK clients. Prior to joining Baillie Gifford, Anthony worked at Abbey National Asset Managers and prior to that, at the stockbrokers Bell Lawrie White. Anthony graduated LLB in Law from the University of Glasgow in 1988.