Attitudes to liquidity vary, this crypto-ATM is in Estonia, it is unlikely to be found in many British banks

Michelle Teng has written a really useful article in Professional Pensions which is free to read and well worth your time. If you aren’t already subscribed to Professional Pensions, this article could be the reason to sign up.

This article explores liquidity in UK pension schemes (thankfully little exposed to current crypto-currency issues)

Michelle’s general argument is that most pension funds (and endowments) manage risk via volatility measures but do not manage liquidity with the same zeal. Since liquidity has been the cause of much financial pain – from Woodford to LDI, it is surprising to her that larger funds do not have a chief liquidity officer managing a team monitoring whether a fund has  too little or too much liquidity.

Coincidentally , this issue is also explored by the FT’s Emma Dunkley this week

Years after Woodford’s crash, what have fund managers learnt about illiquid assets? https://t.co/ybgneVk1k7 via @EmDunks

— Josephine Cumbo (@JosephineCumbo) February 28, 2023

Liquidity or “cash” as most of us call it, is a major issue for the FCA and its current thinking on value for money. Wealth managers who charge fees for keeping their clients in cash may be considered in breach of their consumer duty. Retaining interest earned on client accounts may be considered theft – it was the subject of the bulking scandal that rocked South African financial services in the early years of this century.

Ironically, the pension freedoms now mean that any funds held within a DC pension pot can be liquidated by a client at short notice and a substantial proportion of pots are “cashed out” by state retirement age (if my reading of the FCA’s  Retirement Income Survey is correct). Many other pots are stripped of their tax free cash from 55 onwards, meaning that schemes typically include high cash allocations to life styled or target dated defaults from their early fifties.  Understandably, trustees and fund managers would rather “play it safe” on claims than risk liquidating quoted equities , bonds – or worse illiquids.

Of course, some claims on a DC fund come at any time in a saver’s career, a proportion of savers die young, savers may choose to move money to another scheme or a retail fund and most schemes offer switching options between funds. A more serious threat to liquidity is that of scheme consolidation. What these liquidity calls create is a reluctance in trustees to commit to long-term illiquid assets,

The risks of owning unwanted illiquids is also a reason for DB trustees to avoid investing in “patient capital” – insurers looking to take on a scheme’s assets at buy-out may not view your assets as their assets , meaning your scheme may be priced up for liquidity risk or as likely refused a quote.

Meanwhile, liquidity is being thrust upon many DB schemes who have maintained their LDI hedges, buffers have increased since the LDI crisis to a point where liquidity levels required to support potential collateral calls make the viability of some LDI strategies , questionable.

Ironically, most of the reasons that pension schemes hold large amounts of cash – whether DB or DC – is to protect sponsors or savers from the kind of outcomes that befell investors in Woodford and LDI pooled funds. Michelle Teng points to the need for liquidity management to enable

 a long horizon in a world brimming with large and growing portfolio allocations to illiquid private assets.

But while we need pension funds to grow their exposure to illiquids, we also need to manage the pressures on funds to value their assets against liabilities on a mark to market basis. This pressure led to the herding of DB schemes into leveraged LDI and to the excessive exposure of many  later-stage DC  lifestyle strategies to corporate bonds and long dated gilts.

The DB endgame and the DC endgame are increasingly defined by target dates. In DB the target date may be for buy-out or self-sufficiency, for DC schemes , the target date is the point where a member takes charge of their assets and transfers money into an investment pathway or an annuity or simply “cashes out”.

Ironically, the “long horizon” that is assumed for pensions is increasingly a limited horizon and until pension schemes are encouraged to pay pensions – rather than hand assets to insurers, we will see liquidity management assuming claims on DB and DC measured in years rather than decades.

Illiquid funds aren’t ATMs and are consequently unsuited to most pension schemes with short term aspirations to liquidate. It takes a brave CIO to assume a long horizon and he or she gets little support from the Pension Regulator’s funding code or from the noise around DC  consolidation and the clamour of pension freedoms.

The CIO, like the saver, needs the long investment horizon that comes from open pension scheme paying out lifetime incomes.