Liquidity requirements create a balancing act for your clients’ Defined Benefit (DB) plans.
Hold too little and you can’t pay participants’ benefits, which is a disaster on many fronts. Insufficient liquidity can also lead to forced sales of assets at derisory prices. However, if you hold excess cash, the portfolio incurs opportunity costs in the form of lost returns.
Each defined benefit plan has its own liquidity needs, of course. Some may be facing large and recurring cash outflows while others may be considering a transfer of pension risk, which may indicate increased liquidity levels. By contrast, other DB plans operate with time horizons of 30 years and longer, and in those circumstances reduced liquidity can make sense, says Nick Davies, partner at Mercer.
A recent white paper from SEI Investments, “Investment Liquidity: Investment Lock-ins Investors Should Love”, argues that, in appropriate circumstances, DB plans should consider adding less liquid assets to their portfolios. Tom Harvey, Director, Institutional Consulting at SEI, notes that DB plans often hold around 80% of funds in highly liquid assets, with the balance invested in semi-liquid and illiquid assets. Shifting funds to the latter two categories could benefit many of these schemes, he argues.
The SEI paper highlights four potential benefits of adding less liquid assets:
- Improve portfolio efficiency
- Earning compensation for assuming the illiquidity risk factor
- Increase long-term diversification with the aim of improving risk-adjusted returns
- Create opportunities for managers to create alpha
John Delaney, portfolio manager at Willis, Towers, Watson, argues the role of low liquidity investments in a portfolio. “We believe you need to make extensive use of daily liquid, semi-liquid and illiquid strategies in order to generate the maximum type of return for a given level of risk,” he says. “We see premium illiquidity or illiquidity risk as another type of tool to increase returns.”
Degrees of illiquidity
Generally speaking, investors often think in terms of daily liquidity or long-term lock-ins, Delaney says. But that characterization is overly simplistic, he explains, noting that many investments fall between the extremes, with some having quarterly or annual liquidity and others having medium-term lock-ups. These investments are “certainly worth considering by various plans, even if they have some sort of termination target within the next five years. They could increase yield in the future and potentially reduce the amount of money the plan sponsor has to shell out to achieve their end goal or goal.
Harvey points out two considerations when increasing allocations to less liquid assets. The first is the degree of contractual illiquidity – the constraints – that a plan is willing to accept. For example, a hedge fund manager might allow investors to request withdrawals at any time, but reserve the right to temporarily halt redemptions by imposing a “gate” during turbulent markets. A property manager can enforce a queue and require investors to wait until enough real estate has been sold to fund withdrawals. A truly illiquid investment, such as a private equity deal, could involve locks that prevent withdrawals for 10 years.
While it’s important to maintain an appropriate liquidity profile in the portfolio, plans shouldn’t focus solely on contractual withdrawal agreements, warns Harvey. “If the assets themselves that they’re investing in, maybe it’s distress debt, maybe it’s something like that, aren’t traded on an exchange, not very liquid, you’re wrong. if you have the liquidity that you think you have on a contractual basis,” he says. As the paper notes, when a crisis hits, a panicked herd mentality can cause multiple investors to try to sell their holdings simultaneously. The result can be a struggling market with significantly reduced valuations in the short term, assuming the market for the asset does not completely freeze. Hence the title and thesis of the article: liquidity constraints can protect the underlying portfolio against forced and untimely redemptions.
Work with sponsors
The case for increasing allocations to less liquid options is compelling, but Davies cautions that there needs to be a degree of comfort with these investments and that higher fees are also associated with them. They involve more due diligence, and smaller, less sophisticated plans may lack the internal resources needed for analyses. This added degree of complexity deters some plans that lack those resources, Davies says, while other sponsors turn to Mercer for analysis and allocation decisions. “It’s not a binary yes or no discussion; but it may be a conversation about the best way for them to specifically request this given their size and internal resources,” he adds.