LGIM discusses ways for defined benefit (DB) schemes to build a stable liquidity pool, while balancing future returns and considering the importance of deep liquidity in light of the significant gilt market volatility of 2022.
2022's significant gilt market volatility threw a spotlight on the importance of deep liquidity. Here's our latest thinking on what tools DB schemes may have available to help build a diverse and stable liquidity pool, while still keeping one eye on future returns.
As DB schemes look to the future and aim to build resilience to market shocks, many will be considering enhancing the mix of assets they hold within the 'top-up' funds that sit beside their liability-driven investment (LDI) portfolio. As a broad rule of thumb, we believe approximately 50% of the assets held in LDI strategies should be held in liquid funds alongside, to help ensure an appropriate amount of assets can be accessed quickly if necessary.
However, these assets do not all have to be held as cash. This is important for most schemes, as while to do so might meet their objectives of having scheme stability and ready liquidity, it would be likely to compromise their other objectives of delivering growth and generating stable cashflows sufficient to pay pensions (Figure 1). Instead, including a dedicated allocation to assets focussed on providing a more liquid and stable return than broader market assets can materially improve the liquidity profile of a scheme. We believe that these assets can complement existing holdings and potentially offer predictable cashflows and maintain expected returns in excess of gilts to help close funding gaps and keep DB schemes on their journey towards endgame.
Why do we need liquidity?
Traditionally, much of the focus with liquidity has been on holding assets that can generate sufficient regular cashflows to pay pensioner liabilities. This, of course, remains very important. Yet in 2022's market turbulence it wasn't known cashflows that presented the real challenge for DB schemes. Instead, this was caused by a series of unknown cashflows (Figure 2) as schemes were required to post additional collateral as the value of government bond holdings fell. And with gilts themselves often a go-to asset for liquidity, many schemes were required to raise cash by selling the very asset that was falling sharply in value.
Extreme as it was, this market backdrop demonstrates why it's crucial for schemes to have several additional taps - a diverse source of liquidity - that can be turned on if they're needed, in addition to the regular plumbing required to pay pensions. A further reason why schemes need a resilient plan for liquidity is that there are other potential unknown cashflows to prepare for too.
Transfer values out of schemes are inherently unpredictable and can be significant, particularly for smaller schemes where senior staff members can hold a significant percentage of the overall scheme. Commutations - where members sacrifice future pension payments in exchange for an immediate lump sum - also need to be taken account of in liquidity planning, as do private asset capital calls, with both the amount and timing of when illiquid asset managers need to draw down on further capital often unknown.
Encouragingly, today's higher yielding bond environment, coupled with the fact that scheme funding levels have risen on balance, means that holding a greater allocation to more liquid assets could now come with a lower opportunity cost.
What factors drive the liquidity of an asset?
Perhaps the most obvious consideration when assessing an asset's liquidity is the size of the market. The larger the market, the deeper the available liquidity pool, as the ability for that market to withstand trades tends to be higher. How often assets are traded is also clearly important: if assets aren't traded very often, their liquidity will generally be lower, even if the actual size of the market is significant.
There's a third factor that's also crucial: who holds the underlying assets? If assets are overwhelming owned by similar investors, this can present liquidity challenges. That's because if an investor needs to sell an asset to meet liquidity requirements, there's good chance that other investors in the same market sector also need to sell for similar reasons, thereby reducing an asset's liquidity when it's most needed. With around 50% of sterling corporate bonds owned by UK pension schemes1, 2022 brought the importance of understanding this factor - and diversifying accordingly - into sharp focus.
Pensions schemes need consider price clarity when gauging liquidity too. In other words, is an asset regularly marked to market? Additionally, investment and central banks' willingness and ability to keep assets on their balance sheet needs to be taken into account: in times of financial pressure, these institutions can support liquidity by buying when others need to sell, but they're only likely to do so with assets that they are keen and able to hold.
Stability of returns is equally as important
The second key aspect to consider when building an allocation to more liquid assets is their stability. In fact, we believe that stability is just as important as liquidity. That's because it's not particularly helpful to own an asset that's extremely liquid if it's also fallen significantly in value at the same time as you need to sell it.
Using 2022's turbulence in both risk assets and interest rate markets as a case study, several asset classes, including longer-dated bonds and equities saw falls of 20% or more in relatively short order (Figure 3). Equities, in particular, remained highly liquid, but actually using them for liquidity would have entailed crystalising significant losses. For pension schemes, therefore, it's the combination of liquidity and stability that is absolutely crucial, particularly at times of sharp moves in either inflation or interest rates.
In this vein, LGIM's Absolute Return Bond Fund exhibited greater stability than traditional credit strategies and equities during 2022, and particularly during the large market moves in the third quarter of the year; it also remained highly liquid throughout, meeting 100% of redemption requests (despite them amounting to over 50% of its total value going into the period), with trading costs averaging only 0.23%, compared with 0.17% in standard market conditions.
What does this mean for portfolios?
Bringing this all together, we can see that DB schemes need to build portfolios that - in addition to generating cashflow to pay pensions as they fall due - offer a broad pool of liquidity with varied return drivers that is diversified across several asset types and regions. It's these diverse sources of liquidity that schemes can potentially look to draw upon in the event of unknown cashflow requirements, in a range of different market environments.
Figure 4 describes the typical features we believe are desirable to enhance both liquidity and stability. The need for liquidity and low trading costs should be carefully balanced in portfolios with a focus on downside risk management and reduced correlations to interest rates by focussing on lower duration assets, to reduce the chances of having selling assets that have fallen significantly in value. Depending on their need to close funding gaps, schemes can also look for portfolio assets that aim to offer additional growth potential, while also retaining a balance of liquidity and stability.
How can LGIM help to meet your scheme's needs?
Defined benefit pension schemes can access a wide range of fixed income opportunities at LGIM that seek to offer both diverse sources of liquidity and stability while retaining the potential for returns in excess of cash (Figure 5).
For schemes happy to trade some short-term stability to seek greater potential long-term returns, we also offer a range of diversified growth strategies and index equity funds.
For further information about LGIM, please visit https://www.lgim.com/ or contact your usual LGIM representative
1. Source: Pension Protection Fund's Purple Book 2022. *Please refer to the prospectus of the fund and to the key investor information document before making any final investment decisions. For further information please visit our fund centre LGIM Fund Centre
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