The importance of positive pension scheme cash flows

A pension scheme’s cash flow is its annual income minus its annual expenses. The primary sources of income are (i) employer and employee pensions contributions and (ii) investment income from the assets in the pension fund (e.g., stock dividends, bond coupon payments). The primary expense is the payment of promised pensions to those in retirement.

Positive cash flow (i.e., income greater than expenses) greatly diminishes the risk of remaining invested in growth assets such as equity (stocks), whose expected returns are higher than those of bonds. As First Actuarial explains in their submission to the 2014 valuation of USS:

6.7 While the net cash flow is positive, there is no need to sell any assets and therefore no disinvestment risk to the USS. Low market prices are beneficial during this {…} period of positive net cash flow [because assets are being purchased more cheaply], so a measure of risk which suggests a market fall is a problem would be giving a wrong message.

6.8 While there is no requirement to sell assets, volatility from market value fluctuations is not a concern for the USS: the main concern is the volatility in asset income. Measures of risk and funding level which are market value sensitive, as opposed to asset income sensitive, are likely to be inappropriate in this context and should be given little attention.

6.10 In the {…} scenario of USS continuing as an open scheme sponsored by employers with a robust covenant, the issue of very high relevance is the rate of growth of asset income. Income uncertainty, not market value volatility, is the key issue for the scheme.

As we can see, moreover, from graphs such as the following, dividend income from equity is much more predictable and less volatile than the asset price:

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Source: Robert Shiller, Irrational Exuberance, 3rd ed.

Analysis by First Actuarial indicates that, as a result of the recent cuts to DB pensions, USS will remain in positive cash flow for the next 50 years if its DB section is allowed to remain open and ongoing at its current level.

If, however, as many employers would like, USS is closed to future DB accrual — and future contributions are therefore redirected from DB into individual defined contribution (DC) pension pots — then the DB scheme will immediately become cash flow negative and USS will need to start selling assets to meet its pensions obligations.

The existence of a positive cash flow in an open, ongoing scheme is relevant to an assessment of the level of risk of remaining invested in growth assets such as equities. Hence it is relevant to the establishment of the appropriate level of downward prudent adjustment to the discount rate that is called for by existing UK pensions regulations. But the presence or absence of positive cash flow is otherwise irrelevant to the question of how well funded the scheme is by the lights of current regulations. It could be, for example, that a scheme is underfunded because each person’s employer/employee contributions plus investment returns are insufficient to cover his pension liabilities, and that it is cash flow positive simply because of increases in contributions arising from the growth of membership, year on year. In this case, it would be well-funded because cash flow positive only in the sense that a pyramid or Ponzi scheme is well-funded because cash flow positive. See this addendum to this post for more on when it is and is not appropriate to describe a DB pension scheme as a ‘Ponzi scheme’.

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