A case study in liquidity – because when it rains, it pours!
Liquidity management is of increasing importance on trustee agendas with many schemes now paying out more cash than is coming in.
Liquidity management is of increasing importance on trustee agendas with many schemes now paying out more cash out than is coming in. Pension schemes need to manage cash carefully to continue to meet the demands of member benefit outflows. While some cashflows are predictable, such as pensions in payment, others are less so, such as transfer values. Some schemes will also need cash for buy-ins, or for a cash buy-out in the foreseeable future. In days gone by holding an allocation to cash was a straight-forward way of meeting cashflow needs. But low interest rates mean holding cash is a drag on overall return. Instead, pension scheme investors have turned to longer-dated and less liquid cash-generating assets which offer a higher potential return. Sacrificing liquidity for return may have other implications. It reduces portfolio flexibility and could cause a liquidity squeeze in stressed market conditions or if unexpected cashflows are required. To avoid a cash-22 situation (excuse the pun) trustees should look to understand their current portfolio liquidity and the impact of different scenarios.
An emerging theme within the world of pensions is trustees being asked to consider the liquidity of their assets. But the questions trustees face often come from conflicting angles. Do you have enough liquidity? Could you afford to commit more to illiquid investments? Can you meet your short-term cashflows? Will you be ready for buyout in 10 years? One could meet such heavy questions with a cursory glance at the portfolio, a shrug of the shoulders, or even a look of total disinterest. Those responses are entirely understandable as liquidity is an abstract concept, but the question deserves deeper consideration.
Liquidity is far more complex than a question of how quickly you can sell your assets, according to the dealing terms of your investments. A comprehensive answer would consider which scenarios are likely to lead to a strain on your liquidity – perhaps a market crash, or a big uptick in transfer values.
This paper addresses the main considerations and focuses on a case study which illustrates how we look at liquidity, to help trustees answer these questions confidently.
The main concerns about liquidity
In a world where money has become numbers on a screen rather than cash in hand, it's easy to slip into a false sense of financial security. The reality is assets aren't always accessible when we need them, and that's the essence of liquidity risk. For individuals, this materialises in the form of a 'rainy day fund' – when the unexpected happens you want to be sure that your savings can come to the rescue. For pension schemes, trustees need to be comfortable that they can answer the following questions:
- Do you understand what proportion of your assets you need to keep liquid to meet your short-term cashflow needs, and what can you make use of over the long-term? Analyse your future cashflow requirements and put in place a plan for meeting these payments.
- Are there assets which you must keep for strategic or risk management reasons? Selling these assets could introduce unintended risks or additional costs.
- How should you manage unexpected cashflows? Transfer values are difficult to plan for and create an additional strain on cashflow requirements.
- How do stressed market conditions impact your ability to meet your cash requirements? It's prudent to prepare for the worst. Is there merit in keeping a buffer? If so, how much? Consider the options available with a particular eye on costs in both 'normal' and 'stressed' conditions.
- Is there sufficient liquidity to implement future strategic changes? If de-risking, buy-in or buy out is on the horizon this should be at the forefront of your thinking.
What are liquid assets?
Liquid assets are those which are readily convertible into cash with little impact on its value when sold. Therefore, there are two important considerations when evaluating the liquidity of an asset; the time it takes to sell the asset, and the cost incurred in the market when it's sold.
If liquidity were a hierarchical ladder, private assets would perch on the bottom rung whilst cash sits at the top. The “Liquidity Ladder” is a form of analysis which orders your assets by how liquid they are as well as what order you should tap into them to fund cashflow.
Meet 'Scheme X', which has £250m of assets and is targeting buy-out in 15 years. The scheme has an allocation to growth assets, to pooled LDI, and a Cashflow Driven Investment ("CDI") strategy. The scheme's funds have different dealing terms, some allowing disinvestments daily, weekly, monthly, quarterly or longer. In particular, the scheme has an 30% allocation to illiquid assets, which looks attractive from a yield perspective but locks up scheme assets for over a year.
At first glance, Scheme X's assets look fairly liquid - the trustees could theoretically sell 38% of their assets in under a week and 66% in 3 months.
The trustees hold pooled LDI to manage interest rate and inflation risks in the liabilities. If they sell these assets, it would reduce the level of liability hedging and increase exposure to interest rate and inflation risks. The CDI strategy is held to meet the next 15 years of benefit payments and so disinvesting some assets prematurely will disrupt the cashflow-matching nature of the portfolio. Therefore it is sensible to exclude LDI and CDI assets from the liquidity analysis in this case.
This leaves a smaller pool of assets that the trustees would feel comfortable disinvesting from to meet unexpected cashflows, such as transfer values.
Now consider a scenario of stressed market conditions. Below we illustrate the impact of a fall in the growth assets value and a rise in interest rates expectations. The rise in interest rate expectations results in a collateral call from the LDI manager which must be funded from the most liquid assets to maintain the strategic target for risk management purposes. The combined effect is a significant reduction in the overall liquidity of the portfolio. The scheme would only have 12% of assets which it could realise quickly to meet unexpected cashflows, potentially resulting in a liquidity crisis!
This case study shows that portfolio liquidity may not be as high as expected and may not be sufficient in the event of market stress. Performing this type of analysis is important to ensure there is adequate liquidity now, and for any strategic changes under consideration.
Whilst illiquid assets might offer attractive returns and cashflow generation compared to more liquid assets the impact on overall portfolio liquidity might be too high for a scheme to bear.
... scheme X had segregated LDI instead of pooled LDI?
A segregated LDI mandate offers far more flexibility than a pooled arrangement. Not only can segregated mandates be tailored to investors' bespoke requirements but they also afford far greater control over collateral management. Pooled LDI mandates are typically more capital intensive, i.e. the minimum level of collateral required is higher than a segregated approach for the same level of hedging. By switching to segregated LDI scheme X would have 'excess' collateral which could be allocated elsewhere in the portfolio or held as a buffer against adverse events.
That's why we believe all pension schemes should have access to a segregated LDI mandate, and we implement these on behalf of most of our clients, without the minimum fees that typically restrict these mandates from all but the largest of pension schemes.
... scheme X had a full Cashflow Driven Investment strategy?
Instead of holding a diversified portfolio of assets the scheme could hold a portfolio designed to fully match its future cashflows. This provides greater certainty of meeting expected cashflows but could cause liquidity issues if there are unexpected cashflows. Selling CDI assets before maturity means cashflows won't be matched as originally planned and is more expensive than selling more liquid assets.
Instead, we favour a partial Cashflow Driven Investment approach, aiming to address benefit outgo over a 5-15 year time horizon. For more information on our approach to CDI please read our briefing note.
... scheme X wanted to change their strategy?
A 30% allocation to illiquid assets presents some challenges when looking to adjust scheme X's strategy:
- A large allocation to illiquid assets reduces the ability to allocate to assets dynamically as opportunities arise reducing the ability to manage risk and drive return
- De-risking moves must be funded from the liquid assets increasing the concentration in illiquid assets
- Whilst full funding on a buy-out basis could be reached successfully if there are insufficient liquid assets this could delay the buy-out transaction or increase the cost of buy-out
That's why we believe the size of a scheme's illiquid allocation must be proportionate to its liquidity needs and strategic goals. Illiquid assets must offer strong risk-adjusted returns relative to traditional assets, and we ensure only the best opportunities make their way into our clients' portfolios.
What should you do?
To assess liquidity, you need to think carefully about your scheme's current position, future needs, and long-term goals. We recommend taking the following steps before committing to any additional illiquidity.
- Establish your scheme's objectives and the range of timescales in which you could reasonably expect to achieve them. If de-risking, buy-in or buy-out come anywhere into the equation, think carefully before locking into any form of illiquidity.
- Take a deeper look at your cashflow needs over the next 5-10 years. How will you meet those cashflows, and will you still be able to do so if markets crash or your cashflow needs increase? Make sure you have enough assets set aside so you won't need to sell your CDI or LDI and remember collateral requirements can put an extra strain on liquidity if interest rates rise or if inflation falls.
- Consider ways to reduce your liquidity risk. Assets with low volatility and low trading costs are ideal 'rainy day funds'. If you are using pooled LDI then consider a segregated approach to increase portfolio flexibility and liquidity. CDI can help manage expected cashflows but be wary of locking too much away in case unexpected cashflows hit.
River and Mercantile Solutions, March 2020.
River and Mercantile Solutions is a division of River and Mercantile Investments Limited, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority (Firm Reference No. 195028; registered in England and Wales No. 3359127) and is a subsidiary of River and Mercantile Group PLC (registered in England and Wales No. 04035248), with its registered office at 30 Coleman Street, London EC2R 5AL.
Please note that all material produced by River and Mercantile Solutions is directed at, and intended for, the consideration of professional clients only within the meaning of the Financial Services and Markets Act 2000. Retail clients must not place any reliance upon the contents. The information expressed has been provided in good faith and has been prepared using sources considered to be reasonable and appropriate. While this information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This document may also include our views and expectations, which cannot be taken as fact.
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