A case study in liquidity – because when it rains, it pours!
Liquidity management is of increasing importance on the agendas of trustees and plan committee members, with many plans potentially now paying out more cash out than is coming in and with the recent market volatility having a negative impact on asset levels. Pension plans need to manage cash carefully to continue to meet the demands of member benefit outflows. While some of these cashflows are predictable, such as monthly pensioner payroll, some plans will also need additional cash for items like lump sum or DROP payments.
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 plan 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 and committee members should look to understand their current portfolio liquidity and the impact of different scenarios, especially scenarios where cash needs rise at the same time markets are challenged.
Many trustees and committee members may be approaching their next investment committee meeting with questions such as;
- What has been the plan’s funded status?
- Should we be rebalancing back to target or even add risk?
- Should we protect the plan further from additional losses?
However an emerging theme within the world of pensions is trustees and investment committees considering the liquidity of their assets. But this liquidity question often raises potentially conflicting concerns about where to raise liquidity, how much should be raised and can you afford to increase the amount of illiquidity. These concerns are difficult to understand quickly without taking a deeper consideration.
A consideration of liquidity overall is far more complex than a simple question of how quickly you can sell your assets. A comprehensive answer would consider which scenarios are likely to lead to a further strain on your liquidity – perhaps further downside equity market pressure, and/or a big uptick in lump sum or DROP requests or perhaps both.
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 materializes 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 plans, 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? Develop scenario analysis of your fund’s 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 and/or additional costs.
- How should you manage unexpected cashflows? DROP payments and lump sums 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 asset allocation changes?
Meet ‘Plan X’, which has $100m of assets. The plan has an allocation to liquid growth assets ($50M), alternatives ($30M) and to fixed income ($20M).
The plan’s funds have different liquidity terms, some allowing disinvestments daily, weekly, monthly, quarterly or longer. At first glance, Plan X’s assets look fairly liquid – the plan could theoretically sell about 70% of the assets in under a week and two thirds within 3 months.
In breaking down the $70m liquid portfolio, the plan will typically have an allocation to help hedge against interest rates, inflation and manage its volatility, thus these assets will be desired to be maintained at a certain level or percentage of the plan’s liabilities. For this example, let’s assume that amount was $20M.
Adjusting for the hedged pool of assets, this then leaves a smaller pool of assets ($50M) that the trustees and/or investment committee would feel comfortable disinvesting from to meet both expected and unexpected cashflows, such as DROP payments or lump sums, or about half the entire portfolio.
Now consider a scenario of stressed market conditions similar to what we are currently experiencing (equity markets down 20%). Below we illustrate the impact of a fall in the growth assets and a fall in interest rates expectations (increase in fixed income returns). The effect is a significant reduction in the public equity market holdings with an increase in the hedging assets. This has been the recent result of the Coronavirus impact on the markets. The plan, as a result, would only have 40% of assets which it could realize quickly to meet unexpected cashflows, without reducing its hedged asset pool below the desired $20M goal.
When you consider that many pension plans have benefit payments exceeding 5% of the market value of assets, one can quickly calculate that a prolonged recession could erode the liquidity pool, especially if incoming contributions are constrained.
This also leads into illustrating how impactful it can be if these assets need to be sold at depressed values. The next chart shows the impact if liquidity is gained through the sale of the equity values in a down market. Thus having to sell those assets that can rally back at the wrong times can lead to locking in losses and impacting the funded status long term.
This chart shows the step down and impact of raising $5M of cash from the liquidity portfolio on the plan. It compares raising $5M of cash from either the equity portfolio or the fixed income portfolio after a 20% equity market decline.
The analysis concludes that given the current market conditions (equities down 20% but fixed income up since January 1), selling out of the equity markets will disadvantage a plan if equities were to recover. In fact, it also shows that it would take over a 25% upward equity movement to return to the original market value minus the $5M in benefit payments.
However, this can impact the hedging assets described above. In this example, we raised the concern of not allowing that pool of assets to fall below $20M. Raising the $5M amount shown above from all fixed income would in fact draw down that pool below the $20M threshold.
Thus the plan will increase its short term risk by pulling the liquidity from the distressed public market equity bucket as the hedging assets could fall below the desired hedging target. While most plans express their hedging portfolio as a percentage of assets, it should be thought of as a percentage of the plan’s liability (being equivalent to the present value of future benefit payments+drop payments+lump sums) since it is the future liability that is being hedged.
The conclusion from the above is that even though this plan started with about 70% of its portfolio being liquid, a distressed market, combined with a material cash need, could quickly force the plan to sell assets that could disadvantage the plan materially going forward once markets rebound.
This is why we believe the size of a plan’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 plan’s current position, future needs, and long-term goals. We recommend taking the following steps.
- Establish your plan’s objectives and the range of timelines in which you could reasonably expect to achieve them. Any potential de-risking, DROP payments, or large lump sum amounts should be a material aspect of this planning. 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? Can you meet them if incoming contributions are constrained? Make sure you have enough assets set aside so you won’t need to sell your hedging portfolio.
- Consider ways to reduce your liquidity risk. Assets with low volatility and low trading costs are ideal ‘rainy day funds’.