The dynamics of pension scheme cashflows change, and can change rapidly.
During the stressed markets of March 2020, many prior assumptions and established market relationships were challenged. Significant margin calls on hedging positions, though substantially met, demanded liquidity which came at a ‘price’.
Global interventions from late March helped stabilise the markets but some structural weaknesses, including the potential for inter-dependencies to amplify liquidity demands and give rise to systemic risks in the wider financial system, were identified. This led to the Financial Policy Committee of the Bank of England increasing its focus on improving the resilience of the system and work with other regulators to deliver that improvement.
Pension scheme liquidity
The liquidity requirements of pension schemes vary but some common characteristics can apply. At one end of the spectrum many defined contribution (DC) schemes, that expect contribution income to exceed outgo for some considerable time into the future, can adopt a longer-term approach to their investments and may have a significant appetite for illiquid investments. Open or immature defined benefit (DB) schemes may adopt a similar approach.
At the other end of the spectrum, closed and very mature DB schemes that find that meeting benefit outgo on an ongoing basis is a key concern, or that are focused on transferring their scheme to an insurer, may need to adopt a shorter investment horizon. They may need to focus more on maintaining ongoing sources of liquidity and may have a limited appetite for illiquid investments. However, the dynamics of individual scheme cashflows are unique and they can vary with the fortunes of their sponsor and the scheme’s investment arrangements.
Following the global financial crisis, new opportunities to invest in debt arose as credit risk became increasingly intermediated outside the banking sector. However, the search for yield led some investors further down the yield curve and also into some categories of alternative investments. This has made them more vulnerable to sudden shifts in market sentiment, financial conditions tightening and market liquidity. Against that background, we have become more interested in understanding how trustees manage their scheme liquidity risks and to ensure that trustees actively monitor and manage their scheme liquidity requirements.
- In 2019, following discussions with the Bank of England we carried out a survey of some of the largest DB pension schemes to help understand the extent to which risks could arise.
- In March 2020, as part of our COVID-19 guidance, we emphasised the need for trustees to consider their liquidity needs and how they might develop.
- In June 2020, in our interim guidance for DB Superfunds, we included a requirement for a liquidity risk management plan to be prepared.
- Later this year, when we launch our second consultation on the new DB funding code, we will include requirements in relation to the assessment and management of liquidity risk.
Investment in illiquid assets may offer trustees the opportunity to capture an illiquidity premium, improve the overall risk and reward trade-off and improve outcomes for their scheme members. However, the extent to which trustees decide to invest in illiquid assets should be determined by their scheme characteristics, including their investment, risk management, governance and funding arrangements and consideration of the holding structure for those investments and the degree of investor protection embedded.
Ultimately, we want trustees to better understand the cashflow and liquidity dynamics of their scheme, how those dynamics might develop in the future and how they might change in times of market stress. We also want trustees to better understand the impact that margin calls might have on those dynamics and how ‘mark to market/mark to model’ impacts might reflect on the values of assets realisable in times of market stress.
New code of practice
We recently launched our new code for consultation, which has now closed. We will now be reviewing comments received and will adapt the code where appropriate.
In the draft code we set out an expectation that ‘Unless there are exceptional circumstances, governing bodies should ensure no more than a fifth of scheme investments are held in assets not traded on regulated markets’. We understand that this expectation caused some concern.
We acknowledge that there are a range of investments which may not be ‘admitted to trading on regulated markets’ but which may be suitable for pension schemes to invest in, for example, direct investments in property, forestry, infrastructure or renewable assets or investments in closed ended limited partnership agreements where the underlying investments are unlisted. In our experience, few schemes have very significant holdings of these assets. However, we have observed a few smaller schemes where the trustees have sought to exploit the underlying principles of the OPS (Investment) Regulations 2005 and have invested significantly (up to 49%) in unregulated investments.
In issuing our code for consultation, we believed it would be helpful to set out an appropriate maximum allocation for any scheme other than in exceptional circumstances. However, we do not want this expectation to limit the ability of trustees to invest in assets which may be illiquid and which may offer the opportunity of improved scheme outcomes, once they have taken appropriate advice and understand their scheme’s liquidity risks.
We acknowledge that some concerns have already been raised, particularly around the level of the limit and we are considering what adjustments might be appropriate. We welcome views on the draft expectation that we have set.
In late March 2020, the inception of a massive programme of government and central bank interventions across the globe helped to stabilise the markets. However, future interventions cannot be guaranteed and the Bank of England’s Financial Policy Committee is working on (and wants other regulators to help with) improving financial resilience within the market system.
As pension scheme strategies have evolved we believe that trustees have needed to improve their understanding of the liquidity risks their schemes are exposed to and to actively monitor and mitigate those risks. We would expect more robust liquidity risk analysis to be carried out to allow for example, for:
- severe stress testing for simultaneous market shifts
- the extent and composition of derivatives exposure to margin calls
- alternative assumptions that might apply in times of severe market stress and the impact they might have on the ability of assets to be liquidated and their realisable values
Some investments that are not ‘admitted to trading on regulated markets’ may form a useful part of a scheme’s investments and some illiquid investments may offer the opportunity for enhanced returns, better risk diversification and improved scheme outcomes. However, we believe that trustees need to better understand how risks can develop within their schemes, particularly in times of market stress.
By David Fairs, Executive Director of Regulatory Policy, Analysis and Advice