Everything has it’s price, there is no such thing as free lunch- or if we’re talking “liquidity” – a free bar.
We don’t talk “liquidity” in everyday conversation, it’s a term that is mainly used in financial circles and put simply, it’s the measure of how easy it is to turn an investment into cash. If you invest in a public market, you can expect your money in a couple of day, if you put your money in a bank, a couple of seconds but if you invest in a toll road or a start-up company, getting your money out might take years. There is no liquidity in shares of my company AgeWage right now.
DC savers are used to being able to get cash out of their savings when they’re allowed. For most people that currently means when they’re 55 , they can have their savings back as a lump sum , a series of lump sums or as an income. There is no free bar, that liquidity comes at a price, you only get to invest in liquid markets. That is fine for most people.
But it’s not fine for Government, who wants our savings tied up in long-term projects such as the financing of start-ups or the building and maintenance of toll roads. We are asked to look to Australia as an example of a place where you can have illiquidity and a free bar.
Except it turns out, you can’t. It seems that many savvy Australians are drinking at someone else’s expense . Australian Jo Cumbo takes up the story.
A former Australian regulator has called for 90-day notice period to be imposed on withdrawals from superannuation accounts.
Jeremy Cooper, a former dep chief of the Australian Securities Investments Commission, believes the current system is open to gaming by savvy investors
— Josephine Cumbo (@JosephineCumbo) October 10, 2023
Most of Australian biggest superannuation, or pension, funds typically hold between 20-30% of the fund in illiquid assets, which are not easily sold or bought.
This does create issues around fairness for members in terms of how these assets are reflected in their pension values
— Josephine Cumbo (@JosephineCumbo) October 10, 2023
Gaming of valuation practices for illiquid assets can creates unfairness for members of a super fund, typically younger, who don’t transfer out. The fund’s performance is affected if an asset is downgraded.
— Josephine Cumbo (@JosephineCumbo) October 10, 2023
@Cooperannuation‘s comments do resonate for the UK where pension funds are expanding into illiquid assets. Australia’s pension funds have been investing in illiquids for decades but the regulator Down Under has recently found defects in fund valuation practices for illiquids.
— Josephine Cumbo (@JosephineCumbo) October 10, 2023
“We rejoice in the fact that these super funds invest in airports and toll roads and all these illiquid assets but at the same time we say if you want your money back, no problem,” Cooper told the Financial Times in an interview.
“That is just pure silly.”
— Josephine Cumbo (@JosephineCumbo) October 10, 2023
Thanks to Jeremy Cooper, not just for the comments but for the phrase “pure silly” – which I hope migrates to the UK. Thanks to Jo for an excellent summary of an excellent article.
We have to learn about the trade-offs that happen when you want the benefits of illiquidity and of a free bar – when it comes to consumption. It’s one or the other – but not both.
In the short-term we can accomodate people taking their money when they want it as they want it, but if we are to move to a pension system where the underlying savings are free for encashment without notice, then there will be trouble ahead
Speaking at a Local Government Conference in Leeds last month, Debbie Fielder, whose-Clwyd LGPS fund is very well funded as a result of long-term diversification into illiquids, told the audience that she was currently having cashflow problems meeting unexpected demands on the fund. We’re in DB land here – where “unexpected” is a lot more “expected” than where pension freedom applies. I spoke with her and about the fund’s dilemma, put simply, those who want large amounts of cash from the fund have to wait and are paid according to rules, otherwise assets are sold in a hurry “a fire sale” and the valuation of the assets falls.
Protecting the value of the assets till “redemption” is at full value is known as “gating” and is part and parcel of the deal that institutional investors sign up to.
Debbie’s job is to order the disinvestments to meet the needs of pensioners and employers moving in and out of the LGPS fund. DC managers need to understand the discipline she applies and need to create redemption strategies that meet the cashflow calls of the DC funds they run. If there is no cashflow plan, because everyone is drinking at the pension freedom bar, then illiquids don’t work, or at least give rise to the kind of problems Jeremy Cooper is talking of.
We either need rules and illiquidity or freedoms and liquidy. We can’t drink at the free bar and expect the higher and smoother returns that come from diversifying into illiquid assets. This is a critical lesson and one that in its Mansion House reforms, the Government seem to have recognised.
It is indeed liquidity which has a cost, and that cost lowers the yields available from liquid instruments. The cost of liquidity is directly related to monetary conditions – tight money such as we have seen progressively introduced by the BoE since late 2021 implies high costs for liquidity. Among other things this means that the illiquids bought in the search for yield in the exceedingly loose markets of 2020 and 2021 are now looking to be very expensive mistakes – the spreads achieved then of .05% to 1.5% are now multiples of that. This is one of the issues which the FCA will have to address in its inquiry into private investment valuations.
Those managers who consider the lack of volatility associated with the infrequency of valuation and pricing to be an attraction of private investments are in for a rude awakening. Perhaps the most useful thing we might do is to stop speaking of an illiquidity premium and start speaking of a liquidity cost when evaluating financial instruments.
In my IFA days(50 years) the management of decumulation worked best by
Apportioning the assets in pots that matured every 5 years
Not all assets are needed today so a strategy of timed maturities allows for illiquidity. Self gating introduces a discipline
Unforeseen events have to be taken from assets outside the individual’s pension so as not to cause a loss in the pension.
Illiquidity isn’t the whole of the problem. Even if the DC fund is growing and there’s no need to sell assets, the assets still need to be valued so that money entering and leaving the fund is “crossed” at a fair unit price. As the standard warning about property says, value for these assets is generally a matter of opinion rather than fact. Combine that with infrequent valuation, and the savvy (dis)investor in a growing fund still has an opportunity.