What can lean manufacturing teach us about pension scheme investing?
“Jon, where is that report? Our 2020 cashflow-matching business plan has to be submitted by the end of the day!”
The concept of cashflow matching had been a fertile source of discussions with many defined benefit pension scheme clients, so the document was key to our team’s future planning.
I blinked. I had just read a news story on a North West manufacturer, which reminded me of a discussion I once had with my father. He used to run a factory in Manchester and had worked through the establishment of “just-in-time”, or “Kanban”, production in UK industry.
Kanban is an approach to manufacturing processes that was devised by Taiichi Ohno for the Japanese automotive company Toyota in the early 1940s. The aim of Kanban is to optimise the management of labour and inventories throughout production.
Production-line principles for pensions
I reflected that trustee boards, as stewards of members’ retirement income, are charged with ensuring both the security of the scheme and that pensions are paid as they fall due. As schemes are becoming cashflow negative, trustees are now seeking their own “just-in-time” approach to matching corporate bond inflows with pension outflows.
Kanban is effectively a system to control inventories and supply by making sure they are in proportion to consumer demand. Producing items “just in time” reduces inefficiencies in both labour and the overall manufacturing process. It can help avoid bottlenecks, and mitigate the risk either of having to purchase parts or raw materials at short notice (and probably higher prices), or of holding high levels of inventory when the money used to purchase this could have gone to more profitable business activities.
The equivalent for pension scheme investing is to identify future cash outflow requirements (potential liquidity bottlenecks) and then to invest in assets of equivalent maturities and in sufficient quantities, in order to manage these future outflows efficiently, punctually and with minimum disruption to overall scheme assets. Schemes can use public, private, developed or emerging market bonds for this purpose.
In principle, if a pension payment is required in four years’ time, a corporate bond with the same maturity could be purchased so that it pays out “just in time”. The beauty of cashflow matching is that it can be planned, implemented and adjusted ahead of time, meaning that the scheme can avoid either having to sell assets at short notice to meet cash outflows, or holding excessive amounts in cash and reducing the amount available to invest in growth assets.
So, just as the manufacturing industry looked to Kanban to improve capital efficiency in processes, trustees are looking to improve the certainty that payments will get paid. Our 30-year pedigree for managing assets in this way for L&G’s insurance business (i.e. avoiding liquidity bottlenecks while maintaining a sufficient level of return) continues to be a valuable real-life example for trustees of how this can be implemented in practice.
Being well prepared for the imminent deadline, after a few finishing touches I was able to send over the plan.
Just in time.