The Pensions Regulator has emphasised that trustees need to consider not just investment risk but also their scheme’s liquidity position as they near their endgame, concerned that some schemes could face a crunch if they fail to plan for stressed scenarios. 

 

Pension funds might not be adequately rewarded for some of the illiquidity risk they are taking, the regulator already observed in late 2019. In its latest annual funding statement, it also included the liquidity aspect, and liquidity features prominently in the new defined benefit funding code. 

 

TPR investment consultant Neil Bull underscored the importance of liquidity in the eyes of the regulator, albeit more as a forward-looking consideration than an immediate one. In the proposed code, “we really wanted to cover this area because it’s pretty important”, he said, explaining that with the code, TPR aims to start the debate and make trustees think about their future liquidity requirements. 

 

Bull said the regulator is not concerned about most schemes, as many keep their exposure to illiquid assets low anyway because they look to invest for buyout. 

 

However, as with every aspect in pensions, “you get a dispersion of behaviour”, he said. “It would concern us if a pension fund started to build up huge amounts of illiquid assets as it approached the mature phase,” he said, and “it would start to concern us when that scheme is on the small side”.  

 

This is because of the greater impact that the transfer-out of even just one or two high earners can have on the liquidity position of a small scheme, he explained, noting that around a third of schemes have fewer than 100 members, something he said was in itself “an astonishing statistic”. 

Some schemes also have guaranteed payout periods, meaning that if a scheme member dies before the minimum period, the scheme must pay the amount due for the period to the survivors as a lump sum. 

 

“Those events can cause quite high cash calls on pension plans,” said Bull, adding that “it’s no use saying, ‘We have this wonderful investment strategy over 20 years’, when suddenly something unexpected happens and you can’t pay”. 

As well as transfers out, this could be a rise in interest rates, for example, which could trigger collateral calls on liability-driven investments, although he stressed that TPR is "quite supportive" of LDI in general. 

 

“Liquidity for most schemes is generally okay until it’s not,” said Bull, recalling how investment grade bonds became illiquid during the 2008 financial crisis. 

 

 

At significantly mature stage, the normal cash outflow of a pension scheme might be 4% or 5% even without unforeseen events, which can often impact a scheme simultaneously – a market crunch could be accompanied by high transfer activity as member confidence suffers, something TPR was concerned about in 2020. While liquidity was restored relatively quickly last year, this is not a given in a crisis. 

 

“Importantly we want schemes not only to look at what their liquidity needs are for expected cash flow but also for unexpected cash flow,” said Bull, adding that knowing the liquidity of an asset 'on average' "doesn’t cut it".

He admitted that liquidity can be difficult to assess for unforeseen stressed scenarios but said schemes need to "look at history as a guide”. 

 

For the vast majority of schemes, there will be no need to panic as most don’t have significant liquidity requirements now; but when schemes come up to their long-term objective, as well as spending time on the amount of risk they want to run, trustees should also think about the level of liquidity they want to have, he argued.

 

“Make sure liquidity covers not just what you expect but also the quirky events, have an eye to the destination you’re driving to, and make sure it’s a good point from a risk as well as a liquidity point of view. The earlier you do that, the calmer the journey. You don't want to get to a destination and think, ‘Oh gosh, I’ve tied up my money in private debt for 10 years, why did I do that’,” he said, recommending that schemes speak to their investment consultants and engage with TPR’s second DB code consultation, which is due to be published before the end of the year. 

 

While the regulator is starting to look at whether schemes are liquid enough, the government is however pushing in the opposite direction, seeking to bring pension fund money into illiquid assets that could help the UK’s economic recovery from Covid-19, like infrastructure or private equity. 

 

For Bull, this is not a contradiction, as pension funds have a relatively long time horizon. “In the code we wouldn’t want to discourage the majority from investing. Having said that, we don’t want to create a free for all situation,” he said. “We want schemes to go through that thought process. They might decide themselves they don’t want nearly the amount of illiquidity the regulator would allow.” 

He added that the use of illiquid assets by pension funds is currently relatively low and that TPR would be comfortable if it was slightly higher “but not if it was excessive”.

 

 

Many schemes have already spent time thinking about liquidity. Director at 20-20 Trustees, Nadeem Ladha, said the key driver for higher liquidity is the cessation of deficit repair contributions, which is more of a cliff-edge situation than maturity, except where schemes close to accrual.

 

“We’re seeing quite a few schemes, with the rebound in equities and increase in gilt yields, where at the next valuation DRCs might stop,” he remarked, saying trustees will want to think about liquidity well before that valuation discussion. “If you haven’t, which tail wags which dog?” he said. Despite this impending stop of cash inflows, he said he has not seen much stress testing around liquidity. 

 

The expected transfer-out activity is another driver of cash outflow, he said, with schemes that still have many 55-65-year-old members more affected. 

 

As schemes mature, and especially when there are no deficit reduction contributions anymore, “the investment strategy partly becomes a treasury function”, he said.

 

“What you don’t want to be doing is regularly [be a forced seller of] assets,” which could be the same ones relied on to generate returns, such as equities, he noted. “You tend to find that schemes that aren’t thinking about liquidity are the same ones that are constantly asking about unplanned disinvestments.” 

 

He said most trustees rely on their advisers to get a handle on liquidity governance, as well as working with their administrators. 

 

Some advisers take a conservative approach to illiquidity. “We have a preference for liquidity, it’s our philosophy that schemes shouldn’t be in those illiquid complex investments,” said Brendan McLean, investment research analyst at Dalriada Trustees. 

 

To invest in private debt or private equity, trustees would need to be sure that they are not looking at buyout within the next 10 years, he said. And while private debt, for example, tends to tie investors in for five to seven years, “if something goes wrong it can be much longer to get the money back, it can become 10 years. It happened in the financial crisis,” he noted. The risk of extensions is mentioned in the small print, but McLean said managers often do not make it as clear as they could. 

 

Another issue he highlighted is that with so many investors hunting returns, the illiquidity premium has come down, making illiquid assets less appealing given their inherent risks. 

 

For his clients, “we prefer multi-asset credit managers. They can go down the illiquidity spectrum, not necessarily in private markets but in high yield and sub-investment grade,” McLean explained, adding that these funds are more liquid and offer suitable risk-adjusted return as schemes derisk. 

 

Where his clients do decide to allocate to illiquids, “we are preferring funds that are open-ended and have more liquidity”, he said, noting that some managers have an insurance parent that has said they can buy back units in the fund if there were redemptions. 

 

The option for managers to ‘gate’ such funds ensuring a more orderly exit is a comfort to investors, he argued, but something trustees must be aware of: “While open-ended funds are generally more liquid, there can be times when they aren’t.” 

 

The most prominent such cases occurred in the property fund space, where several funds were gated after the Brexit referendum in 2016, and again in the run-up to Brexit at the end of 2019.