Author: Luke Isaac
There is no single definition of CDI, but for practical purposes, it can be thought of as a strategy that uses contractual, income generating assets, to meet expected future liabilities (e.g. member benefits for a pension scheme).
CDI has become a prominent feature in the investment landscape, particularly for defined benefit (DB) pension schemes, approaching (or already at) their endgame. At its heart, CDI is not a rigid formula but a philosophical approach. It seeks to meet cashflow requirements in a low-risk, intuitive way. This reduces reinvestment risk and reliance on market timing, helping schemes avoid becoming forced sellers of assets in volatile market conditions.
In practice, adopting a CDI approach often means investing in credit to cover the short-to-medium term liabilities (e.g. the first ten years), and then using gilts to extend the match to longer-dated liabilities. Illiquid assets and derivatives are also sometimes introduced depending on the nuances of the investor in question, e.g. private credit or inflation swaps.
We view CDI as an end game solution which tends to be more appropriate when credit spreads are wide; however, there are a number of risks and considerations to be mindful of to implement a well-designed CDI solution. It's also important to consider this approach in the context of other possible investment approaches to decide which may best suit your needs.
Before diving deeper into implementation, it's helpful to look at the range of asset classes that could feature in CDI strategies. The chart below illustrates some of the options our clients consider. From left to right, the spectrum moves from illiquid to liquid assets, while top to bottom shows a shift from highly contractual cashflows to less contractual ones. Greyed-out items represent asset classes that are typically not included in CDI portfolios, and those marked with a green dot indicate those with a sustainability focus.
The spectrum of cashflow management approaches
We note that not all CDI strategies look the same. In fact, there's a spectrum of approaches, ranging from "pure" CDI, which prioritises cashflow matching above all else, to more "traditional" strategies that focus on risk-adjusted returns while managing cashflows as a secondary concern (i.e. a "Total Return" approach). Below we have outlined some of the key benefits of these two approaches. However, in practice we note the choice is not binary and there's a spectrum of options that lie in the middle (e.g. some asset owners may cashflow match short-dated liabilities and duration match longer-dated liabilities).
Although on paper a CDI approach may seem attractive, there are several points which we believe are crucial to bear in mind.
Implementing a CDI approach: Points to be mindful of
In designing a CDI approach, we note it typically needs to be implemented with LDI rather than instead of LDI for the following reasons:
- Long dated exposures. The universe of available corporate bonds isn't long dated enough to cover all the cash flows of a typical DB pension scheme. Therefore, LDI type assets (e.g. gilts) will often have to be used at the long end of the curve under a CDI approach.
- Inflation. Corporate bonds are unlikely to provide an adequate match for inflation risk, given the (low) availability of index-linked corporate bonds.
- Re-investment risk. One of the aims of CDI is to mitigate re-investment risk. Without LDI, the scheme is exposed to re-investment risk (among other risks) on all cashflows longer dated than the credit holdings.
- FX risk. An LDI overlay may also be needed to support any FX hedges in place (for overseas assets).
We also note in most cases, when allocators are discussing CDI, they are referring to investing in high quality investment grade, corporate bonds to generate cashflows. This is therefore the focus of the rest of this piece. As noted above, a CDI approach could be constructed using a variety of other assets (e.g. infrastructure or real estate) — though these introduce other risks.
The above points are all well and good, but what do they actually mean in practice for adopting a CDI approach?
Flexibility of a CDI approach
Although the common consensus is that a CDI approach reduces reinvestment risk, this is predicated on the assumption that all bonds are held to maturity. However, if sold early, the returns depend on the mark-to-market value, not the cashflow profile.
The assumption of holding bonds to maturity may become challenged under the following scenarios:
- If issuers default on their obligations.
- Even if issuers don't default, issues could arise if the creditworthiness of investment grade credit deteriorates significantly, such that the previous default and recovery assumptions are no longer appropriate. A rewrite of assumptions may necessitate trading in the portfolio.
- If the sponsor covenant deteriorates, and the scheme decides to target buy-out. In this case, the funding position of the scheme will be considered on a mark-to-market basis (i.e., a gilts plus a fixed spread approach for liabilities). If credit spreads widen considerably, a scheme might be considered to be in a weak position even though it may be likely to be able to pay all pension cash flows as they fall due. We note that sponsor strength can change over time.
- "Unknown unknowns" materialise.
Resilience and sources of risk in a CDI approach
The sector concentration and size of the UK corporate bond market (e.g. large weight in financials) means that in order for pension schemes to construct a suitably diversified credit portfolio to implement CDI, they often incorporate allocations to other regions (most likely the US). This introduces FX risk (and foreign interest rate risk). Not hedging this risk would defeat the purpose of "locking in" the cashflows, as USD denominated income will not always exactly match GBP denominated liabilities due to currency movements. Also as mentioned previously, a CDI approach may need to be coupled with an LDI portfolio to cover longer dated liabilities.
Both of these points mean that a pool of collateral may need to be held to support derivative contracts (both for interest rate, inflation and FX hedging).
The consequence of this is that if interest rates or exchange rates spike drastically, this can lead to challenges for a CDI approach as positions which were previously assumed to be held to maturity may need to be sold (potentially at a loss) to cover collateral calls.
In addition, transfers out of a scheme can in extreme scenarios represent an additional 1-2% of liabilities over a year (which could be the same size as pension cashflows). This represents an additional risk of credit assets not generating sufficient cash to cover liability cashflows. We note that as a scheme matures and members retire, this becomes a smaller risk.
In order to successfully implement a CDI strategy, buffers of prudence will need to be incorporated to ensure these unexpected changes do not cause significant issues.
Deciding the right approach for you
Taking into account all the key considerations and risks made above, a key question left unanswered is: should we be adopting a CDI approach? If not now, then when?
In our view, trying to answer this question can be thought of by considering the following:
Market conditions and affordability
At the time of writing, we see investment grade credit spreads at historically tight levels. This reduces the return they provide above traditionally gilt-based discount rates.
The implication of this is that implementing an investment grade only cashflow matching strategy may no longer fully cover all member benefits. This may necessitate investing into higher risk contractual assets (e.g. high yield or illiquid assets), which introduces additional risk into the investment approach.
Whether or not this is an issue depends on how well funded a scheme is, how mature its membership profile is, and how much return it needs to generate (i.e. the "required return"), e.g. a scheme in surplus may be able to meet all member benefits so long as the return on the portfolio generates 50 basis points over gilts. An underfunded scheme may need to generate significantly greater returns.
Portfolio efficiency
As a rule of thumb, when credit spreads are low, even for clients with relatively low required returns, investment grade credit may not be the most efficient way to achieve the scheme's objectives.
If reinvestment risk or the risk of becoming forced selling of growth assets are not strong concerns (further information below), such clients may consider a more diversified growth portfolio. This is true even against simple alternatives, such as pure equities, that offer lower portfolio efficiency than a diversified portfolio.
Illustrative example
Below we provide an illustrative example of the efficiency of adopting an investment grade only CDI strategy over ten years vs. "non-credit" assets.
The rows of the table show credit spreads over gilts, while the columns represent the "required return." We define the required return as the minimum return a scheme's portfolio needs to generate in order for the scheme to successfully reach its funding objectives. The chart then categorises outcomes into three zones based on whether an investment grade credit strategy meets the required return and how it compares to alternatives in terms of risk efficiency (as measured by the Sharpe Ratio).
- Efficient — where the investment grade credit portfolio both exceeds the required return and is more risk efficient than the non-credit assets.
- Inadequate — the return from the investment grade credit growth portfolio is insufficient to generate the required return.
- Inefficient — investment grade credit portfolio exceeds the required return but has a lower Sharpe Ratio than a non-credit asset portfolio.
Source: Gallagher calculations, 29 May 2026. Please note this assumes 20% collateral.
As can be seen, even in this simple illustration, an investment grade only CDI strategy may not always be appropriate, particularly given the current market environment of tight credit spreads. However, at some points it can be an efficient approach to adopt. Of course this is a simplified view and the outputs vary greatly depending the target portfolio structure. We can calculate alternative grids upon request.
Summary
In summary, CDI can be a powerful and intuitive strategy, especially for well-funded, mature schemes with modest return targets, a desire for simplicity and a desire to more closely align their investment strategies with insurers (see previous blog for details of this). However, its effectiveness depends on market conditions, implementation quality and each scheme's specific circumstances. For many, a hybrid approach that balances cashflow alignment with return efficiency may be more appropriate than a rigid framework. The key is to:
- Begin with the end in mind.
- Build a strategy that balances market conditions, affordability, efficiency and resilience.
- Monitor and adjust on an ongoing basis.
If you'd like to explore whether a CDI approach, or a more flexible alternative, is right for you, we'd be happy to have a conversation. Our team has experience designing solutions tailored to each scheme's funding position, governance capacity and long-term objectives.
Thank you for joining us in this instalment of our investment grade credit blog series. We hope this deep dive into the philosophy and practicalities of CDI has provided valuable insights.
