Many pension plan sponsors focus their investment discussions around expected returns and the commensurate risk associated with achieving those returns. However, in times of market volatility, overlooking the third dimension of investing, liquidity, can be disastrous and result in unintentional poor results.
What Is Liquidity?
Liquidity is defined by Investopedia as the ease with which an asset, or security, can be converted to cash without affecting its market price. Liquidity can be seen across a spectrum where on one end you have assets that are highly liquid—i.e. converted to cash in a matter of days and weeks—and on the other end you have illiquid assets—i.e. that take years to convert to cash or take a significant discount to the current market value.
There are two main concerns as it relates to liquidity in an investment strategy:
- Having enough cash on hand to pay promised benefit payments such as annuities and bulk lump sums when due; and
- Not putting the plan in a position where assets are sold at market lows or results in changes to the risk profile of the portfolio in order to raise cash.
Normally, pension plans address liquidity concerns through rebalancing provisions in their investment policy statement (IPS). That generally works well in times when markets are stable and rebalancing can take place through cash flow management. When markets are not stable, and especially when they’re negative, it can lead to sub-optimal outcomes that can affect a plan’s long-term recovery.
The Current Market Environment
The current market environment has put stress on many organizations’ revenue streams. For some, it has resulted in furloughs and layoffs, which may push some employees into early retirement. Many new retirees who need cash may elect a lump-sum payment if it’s available. Lower employer contributions combined with increased benefit payments will further increase cash flow concerns and, thus, liquidity needs.
Ultimately, pension plans exist to pay benefit payments now and in the future. In order to make those payments, plans have to be sufficiently funded and have the cash available to make good on those promises.
How Market Volatility Affects Liquidity
When markets are volatile like we’ve seen over the past three months, the liquid assets that companies use to generate cash for making pension payments can become stressed. For more mature plans, this problem can be exacerbated by an already existing negative cash flow position such as when benefits payments are greater than contributions.
Let’s look at an example of plan that has a potential liquidity problem.
Sample Asset Allocation
Benefit payment profile:
- Monthly annuity benefit payments: $500,000
- Lump-sum payments (deferred retirement option plan [DROP], cash balance, lump sum): $100,000 to $750,000
With this type of profile, after two to three months, the plan will need to raise cash to pay benefit payments. In a stable market environment, it should be straightforward to determine which liquid assets—equities and fixed income—to sell, especially if it helps in rebalancing to IPS targets. Another key point is that it will most likely not be feasible to sell off any alternatives to raise cash due to the illiquid nature of those investments.
However, in times of distress, the decision on where to raise cash becomes more complex. For example, if equity markets are down 15%, you may not want to sell off those investments to raise cash for benefit payments as you would be “selling low.” However, selling fixed income could actually increase your future portfolio risk and may not be optimal either.
This highlights why having a liquidity strategy as part of your overall investment strategy is crucial—it can help you avoid making decisions with unintended consequences and better position your portfolio for the long term.
What Should You Do Now?
Liquidity can be easily overlooked when markets are stable, however, when markets are volatile, you need to have a plan in place for how you will address liquidity. Here are a few steps you should take:
- Plan—it’s important to understand and stress test your benefit payment and contribution profile to understand how much cash you may need (or not need) at any given time.
- Review asset allocation—ensure that you have the right mix of liquid assets in your portfolio that will allow you to make smart decisions for maintaining the right liquidity profile. This could also involve looking at other tools such as derivatives that can provide the risk/return/liquidity profile you need.
- Develop a market view—your organization probably has a view as to what will happen with markets in the short and medium term. Incorporate that into your pension investment decisions with an eye toward what circumstances will lead to a need for more cash.
Taking those action items into consideration will allow you to build a flexible action plan that will lead to better decision making for your pension portfolio.
Tom Cassara is a managing director and head of River and Mercantile’s U.S. business. He is based in New York City. Michael Clark is a managing director in River and Mercantile’s Denver office and is the president of the Conference of Consulting Actuaries.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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