Impact of Liquidity on Pension Funds

Liquidity management has become an important buzzword in the pension fund industry. This is because of the fact that recessions, slowdowns, and the recent market crash caused by Covid-19 have left the pension funds exposed. Many studies have been conducted into the matter and the results from these studies are simply astonishing.

Pensions funds are supposed to be safe for long-term investors. However, in the current markets, pension funds frequently face a shortage of cash. As a result, investment managers have to become more creative to manage liquidity in such cases.

In this article, we will have a closer look at the impact that a lack of liquidity has on pension funds in general.

1. Fire Sale of Investments: Studies have shown that pension funds are woefully short of cash. It has been estimated that pension funds are net sellers of assets in eight to nine months of the year. This is done to make sure that they are able to make timely pension payments to retirees.

   The fact that pension funds have to make sales of long-term assets to fund short-term liabilities raises a huge red flag on the fund management capabilities. This is because of the fact that if pension funds are selling assets to make the payroll, they are not selling at opportune moments. Instead, they are forced to sell at whatever prices are offered by the market. This is the reason that pension funds have been involved in many fire sales in the recent past and have now started paying close attention to liquidity management to avoid this situation in the future.

2. Increases Cost of Investing: When pension funds face a liquidity crisis, they tend to lose money. Hence, in order to avoid the same, companies also increase the amount of cash they hold on their balance sheets. The previous few years have seen the percentage of cash on hand steadily increase across various pension funds.

   The 2008 crisis has spooked some of these funds. During that time, funds were not able to convert assets to cash even at deeply discounted prices. As a result, most funds prefer to hold cash to completely avoid that risk.

3. Risky Investments: Now, since pension funds have to allocate more money towards cash, they have a smaller amount of money left to invest and earn returns. Hence, the return provided by these funds has been in a steady decline over the past few years. The end result is that pension funds are forced to undertake riskier investments in order to make up for the loss.

   For instance, in many countries, pension funds take positions in the derivatives markets against the equity portfolio that they hold. This allows them to take on additional risk in order to generate additional cash flow. However, since derivatives and other such alternate assets can be highly volatile, funds need to improve their liquidity management so that they are not forced to take on additional risk.

4. Shorter Investment Tenure: Since pension funds invest in riskier assets such as mortgage-backed securities, they tend to do it for the short term. This is because it is difficult to ascertain the probability of default on such risky instruments over a very long period. Hence, companies prefer to hold on to these assets for shorter durations. They then roll over the asset and buy new security if their cash flow permits.

   However, the need for liquidity management has changed the pension fund industry. Earlier it was known for making less risky long-term investments. Now, it is known for excessive trading and making short-term risky investments. Pension funds are paying more attention to liquidity management so that their fund managers are not forced to take on excessive risks.

5. Diversification: Pension funds now have a much more diversified portfolio. Earlier a larger portion of their portfolio used to be fixed income securities. Now, pension funds own large amounts of alternate assets. Fixed income securities are still widely held by pension funds. However, these assets are not concentrated in a few companies or geographic regions.

   Pension funds have been making sure that they diversify their portfolio as much as possible. This includes geographic diversification as well as investing in companies of different sizes. This can be considered to be a positive effect of the increasing importance of liquidity management in the pension fund industry.

6. Frequent Rebalancing: When companies are trying to obtain funds in a very short duration, they are forced to sell the most liquid assets. For instance, pension funds may not be able to sell their private equity investment or their investment in an illiquid piece of real estate to pay their short-term dues. Hence, these funds frequently end up with a portfolio that is out of balance.

   Companies often end up with very little debt on their balance sheet since bonds have much higher liquidity than other risker assets held by these funds. The end result is that at a later date, funds have to sell their illiquid investments as well in order to reinvest the money back in the original asset so that the same proportion of assets can be maintained. The end result is constant rebalancing which causes unnecessary transaction costs and brings down the efficiency of the firm.

The bottom line is that liquidity management has become extremely important in pension fund management. The lack of liquidity impacts any pension fund in multiple ways.