DB schemes are juggling the need to have sufficient cash to pay out pensions while still generating returns. Helen Morrissey asks if liquidity ladders are the answer
- DB schemes must ensure they have sufficient liquidity to pay out pensions long term
- Liquidity ladders can be utilised to ensure there is sufficient money to pay pensions while generating return
- Trustees must ensure they understand the nature of investments in their strategic asset allocation so that they are not taking on too much risk
While there is much debate on whether schemes should invest in more illiquid asset classes the fact remains their need for cash has never been greater.
As defined benefit (DB) schemes mature trustees must ensure they have sufficient cash to pay out pensions. This could be exacerbated by the advent of pension freedoms, which can lead to some members choosing to transfer out resulting in calls for sizeable cash payments from the scheme.
In addition, schemes running liability driven investment (LDI) portfolios are also facing the need to hold more cash as regulation around the central clearing of swaps means schemes' ability to post gilts as collateral is reduced.
New banking regulation has also had a negative impact on liquidity via bank deposits and repurchasing (repo) of gilts. In short, cash is becoming more expensive and difficult to access at precisely the time schemes need it the most.
Schemes are also faced with the difficulty of trying to achieve decent levels of return in a chronically low-return environment. Many may feel they simply cannot afford to hold large portions of their portfolios in cash. So what can they do?
One option being put forward is the concept of a liquidity ladder. This comprises three rungs, the first of which is operational cash. This literally covers money in the bank used to service daily needs.
The next rung is reserve cash, which operates as a buffer to operational cash. This is not quite same day cash but still needs to be very liquid and would be made up of gilts.
The third rung is strategic cash. This would be an allocation towards more short dated credit instruments such as asset backed securities (ABS) and absolute return credit strategies. Such assets can have a short delay should investors need to get hold of them.
The idea is that as liquidity is taken out via the bottom rung, it is replenished by the one above.
According to Hermes Investment Management's co-head of credit Fraser Lundie such an approach can help schemes by reducing gilt exposure while increasing outright cash and credit based strategies at either end of a barbell formation.
"This barbelling immediately boosts overall liquidity due to the higher outright cash holding, increases asset return due to the higher credit allocation, and reduces the scheme's basis risk given the reduced assumed gilt vs swap liability," he says.
Such an approach is proving of real interest to schemes according to Redington's head of defined benefit pensions Dan Mikulskis: "It is early days but schemes appreciate the framework and the thought that's gone into it. You have to look at this in the context of the whole scheme. Schemes rightly want comfort that their derivative hedging won't cause them to be forced liquidators of assets at stressed times, this gives them that."
What do schemes need to know?
PTL managing director Richard Butcher agrees such an approach is sensible but says there are issues schemes should be aware of.
"Essentially this is what DB schemes already do at the long end in that we buy gilts at durations that match our liabilities, and extending that to the short term makes sense to me," he says. "The key risk I can see is that while schemes can plan their liquidity needs to an extent there will also be times when miscellaneous cash calls will come that they may not be prepared for. This could happen when members choose to transfer out of a DB scheme for instance.
"If a scheme was relying solely on a liquidity ladder then they might not have access to as much cash as they need which could make them a forced seller of assets. They need to build in some kind of buffer to account for this."
Another important area to consider is that of cost. Research from Redington recommends schemes should not pay more than 10 basis points per annum for a liquidity fund. It argues that anything more will eat into net returns or could incentivise the fund manager to take on too much risk.
Ensuring the fund is structured correctly is also important according to Mikulskis: "The operational element (of how cash will get drawn down the waterfall) is also important to pin down," he says. "A key balance that needs to be struck is having ‘enough' assets in the cash ladder but not excessive amounts as this will detract from the strategic asset allocation. Schemes will generally want as much of their assets as possible to be allocated to return seeking strategies."
He also says schemes need to be aware of the availability and functioning of the repo market as it is one of the first lines of defence when generating cash from gilts. However, he added that while this risk cannot be completely mitigated "the functioning of repo is pretty fundamental to the financial system so it's not too difficult to get comfortable with."
Hermes' Lundie says schemes also need to ensure they really understand the investments they choose for their strategic cash allocation.
"In terms of the liquidity ladder having three different rungs then there is nothing too controversial about the first two rungs," he says. "When we come to the third rung, which aims to generate incremental returns from cash-like strategies, then this is where people need to be careful. For instance, how you define absolute return credit can bring difficulties in that some players will utilise illiquidity premia to get return."
He continues: "We look to do it with daily liquidity in mind. If people go down this route they need to ensure they aren't building in complexity or illiquidity. Some of these other strategies belong further out towards the more return side of the spectrum."
PTL's Butcher agrees saying that schemes "need to take a sensible approach to the assets they include within their liquidity ladder as if they get it wrong they will be forced to look elsewhere for cash or be forced to sell assets."
According to Mikulskis the liquidity ladder approach is something that can be utilised by schemes regardless of size: "Broadly the tools are accessible to all sizes of scheme," he says. "There is a bit of a difference in implementation if you are using pooled LDI. Pooled LDI already contains an element of cash/collateral holding, which is the physical assets in the fund. Also you wouldn't have the ability to do gilt repo if you are in pooled. But the strategic cash, ABS and absolute bond elements are all available in pooled format accessible to all sizes of scheme. Again one important point is the operational functioning of how the assets flow through the different elements of the waterfall, our experience is this can actually be set up quite efficiently even for small schemes."
So as schemes continue to try to find a balance between their need for liquidity and return, strategies like liquidity ladders might prove to be a useful tool.
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