As more schemes move towards buy-out for their liabilities, the capability to efficiently construct cashflow-matching portfolios is of increasing importance to both insurers and pension schemes

In this article, we take a look at how novel portfolio construction techniques offered by asset managers can allow insurers and pension schemes to accurately match their liability cashflows whilst also ensuring their risk appetite and specific fund tolerances are fully considered.

Holistic

With a holistic cashflow matching framework, it's possible to optimally construct portfolios that offer desirable levels of yield, whilst reflecting all possible specific client specifications and restrictions. This includes clients who want their matching portfolio to meet the requirements for Matching Adjustment (MA) compliance under Solvency II.*

As well as portfolio construction, efficient ongoing portfolio management ensures assets are also rebalanced and optimised throughout the mandate life cycle.

Later in this article we will examine the range of assets and different client specifications that can be embedded into a flexible portfolio construction and management framework. But first, what about risk appetites and tolerances?

Flexible

A cashflow matching framework is centred around maximising the correspondence between the asset cashflows and the client’s best estimate liabilities. The asset cashflows may also include haircuts reflecting the probability of defaults, necessary in matching adjustment mandates, for example.

It's through the additional constraints, however, that the portfolio can be tailored to meet client and regulatory requirements. Asset managers’ tools can include:

Such a framework is flexible enough to meet any requirements or risk appetites. It’s also important that asset managers work collaboratively to ensure the client's views and demands are fully reflected in the portfolio construction and on-going fund management tools.

The full client life-cycle and all asset classes

Cashflow matching managers can incorporate the full client life-cycle and a wide range of asset classes ensuring they are particularly well-placed to work with insurers and pension schemes. But what should these clients look for in terms of management skills, tools, capabilities and scale?

Within the industry, the best teams benefit from a suite of proprietary, on-desk cashflow matching tools and use these to manage billions of pounds within annuity and matching adjustment funds. These tools aid portfolio managers and clients throughout the full lifecycle of such funds, detailed below.

With a fast-growing MA market and a limited supply of eligible sterling public securities, it’s a key requirement for MA portfolios to widen the scope of asset classes in order to continue to offer attractive solutions within  a competitive market place.

As such, in addition to sterling investment grade fixed income securities, best-in-class cashflow matching solutions can include overseas debt, such as USD corporate bonds, paired together with cross-currency swaps or repackaged up as a special purpose vehicle.

The capability to model private placements, commercial real estate loans, and infrastructure bonds is also crucial. Naturally embedding such securities allows for efficient management of public credit alongside non-public debt within cashflow matched and matching adjustment mandates.

Quantitative portfolio design

Proprietary quantitative portfolio design can be applied to a wide and diverse investment universe. This design may be tailored to meet clients’ needs and constraints. Such a flexible and transparent process also allows for informed discussion between key stakeholders, enabling comparison of the relative merits of a spectrum of matching portfolios with different ‘risk-return’ profiles.

To illustrate this point, we showcase such an ‘efficient frontier’ of matching adjustment compliant portfolios for a stylised liability profile and a public credit universe in Chart 1 and Chart 2 below.

Chart 1 Matching Adjustment ‘efficient frontier’ constructed from the GBP Public Credit universe. Typical portfolio issuer/sector /rating constraints. Liabilities c. 12-year duration. Close of Business (CoB) 30-Dec-2022.

A "Best cashflow match" portfolio with no yield constraint (meets various portfolio limits & MA CF-Match Tests).
B Better yielding MA Compliant Portfolio (still meeting all limits & CF-M tests).
C Pushing yield at the expense of cashflow match (portfolio only just matching adjustment compliant).

Source: abrdn, April 2023

Chart 2 Cashflow match plots for the three highlighted portfolios along the MA ‘efficient frontier’. Stylised liabilities of c. £1bn PV (present value) and 12-year duration. All portfolios meet the ‘PRA Tests’. CoB 30-Dec-2022.

Source: abrdn, April 2023

The above portfolios also embed insurers’ typical issuer, rating and sector limits and demonstrate the benefits of an optimisation exercise, potentially resulting in a 30 basis point spread gain whilst retaining an acceptable quality of cashflow matching.

A huge opportunity for insurers and pension schemes

With the forecast rise in BPA activity, defined benefit pension schemes are likely to sharpen their focus on preparing portfolios for transfer to an insurance company.

This includes approaching cashflow matching in the same way that insurers currently do. At the same time, insurers can create better optimised portfolios tailored to their specific liability profile and risk appetite.

Asset managers with proprietary techniques and insurance asset management capabilities could be well placed to support both pension schemes and insurers with the BPA journeys that lie ahead.

*A note on Matching Adjustment (MA) compliance under Solvency II

* Within a matching adjustment portfolio, the expected asset cashflows (after allowing for the probability of default) and liabilities should be matched. The PRA have some specified criteria which must be met by the matching portfolio, detailed below:

Test 1. The maximum net cashflow shortfall must not exceed a defined threshold.

Test 2. The risk arising from any rates, inflation and currency mismatches must not exceed defined thresholds, typically based on insurers’ own models.

Test 3. A validation check that firms are not using an MA calculated from too few assets, which could result in firms overstating the benefit of the MA.

The PRA tests are not the only measures/metrics that may be appropriate for a matching portfolio. Indeed, passing the PRA tests would not automatically result in what an insurer may consider as suitably matched.