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 multiple fronts. Insufficient liquidity can also lead to forced asset sales at distressed prices. Hold excess liquidity, however, and the portfolio incurs opportunity costs in the form of foregone returns.
Each defined benefit plan has its own liquidity requirements, of course. Some may be facing large, recurring cash outflows while others might be considering a pension risk transfer, both of which can indicate increased liquidity levels. In contrast, other DB plans are working with time horizons of 30 years and longer and in those circumstances reduced liquidity can make sense, says Nick Davies, partner with Mercer.
A recent white paper from SEI Investments, “Investment Liquidity: Investment Lockups Investors Should Like,” makes the case that in the appropriate circumstances DB plans should consider adding less-liquid assets to their portfolios. Tom Harvey, director, Institutional Advisory with SEI, notes that DB plans often hold about 80 percent 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 plans, he maintains.
The SEI paper highlights four potential benefits from adding less-liquid assets:
- Improve portfolio efficiency
- Earn compensation for taking on the illiquidity risk factor
- Enhance long-term diversification with a goal of improving risk-adjusted returns
- Create opportunities for managers to create alpha
John Delaney, portfolio manager with Willis, Towers, Watson, supports the role of reduced-liquidity investments in a portfolio. “We think that you need to be making a broad use of daily liquid, semi-liquid and illiquid strategies in order to generate the kind of maximum return for a given level of risk,” he says. “We view illiquidity of premium or illiquidity risk as just another sort of tool for adding to returns.”
Degrees of Illiquidity
Generally speaking, investors often think in terms of either daily liquidity or long-term lockups, Delaney says. But that characterization is too simplistic, he explains, noting that many investments fall between the extremes with some having quarterly or annual liquidity and others having intermediate-term lockups. Those investments “are certainly worth a variety of plans considering, even if they have kind of a termination goal over the next five years. They could add to the return going forward and potentially decrease the amount of cash that the plan sponsor has to lay out to have them reach their end goal or objective.”
Harvey points to two considerations when increasing allocations to less-liquid assets. The first is the degree of contractual illiquidity--constraints--a plan is willing to accept. For example, a hedge fund manager could allow investors to request withdrawals at any time but reserve the right to stop redemptions temporarily by imposing a “gate” during turbulent markets. A real estate manager might impose a queue and require investors to wait until a sufficient amount of property holdings have been sold to fund withdrawals. A truly illiquid investment, like a private equity deal, could involve lock-ups 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 arrangements, Harvey cautions. “If the assets themselves they’re investing in, maybe it’s distress debt, maybe it’s something like that, are not exchange traded, not very liquid, you’re fooling yourself if you have the liquidity you think you have on a contractual basis,” he says. As the paper notes, when a crisis hits, a panicked herd mentality can result in multiple investors trying to sell their holdings simultaneously. The result can be a distressed market with valuations reduced significantly for the short term, assuming the asset’s market doesn’t freeze up completely. Hence the paper’s title and thesis: liquidity constraints can protect the underlying portfolio against forced, untimely redemptions.
Working with sponsors
The case for including increasing allocations to less-liquid options is compelling but Davies cautions there’s a certain amount of comfort required with these investments and there are higher fees associated with them, as well. They involve more due diligence and smaller, less sophisticated plans might lack the in-house resources need for the analyses. That added degree of complexity dissuades some plans who lack those resources, Davies says, while other sponsors turn to Mercer for the analytics and allocation decisions. “It’s not a binary discussion of yes or no; but it may be a conversation about what is the best way for them to specifically ask that given their size and internal resources,” he adds.