Liquidity problems are getting worse for asset owners, and particularly for pension funds, due to low interest rates and new regulation, Northern Trust has warned.
The US financial services firm said in a new white paper that asset owners should “future-proof” their investment policies to make sure they had a balance of security, liquidity yield, and operating efficiency.
Mark Austin of Northern Trust’s Institutional Investor Group said: “While the low interest rate environment and associated market dynamics, as well as the regulatory changes focused around liquidity, have affected many institutional investors differently, we see pension funds coming under the greatest pressure as a result of a confluence of these factors.”
Finding and maintaining appropriate liquidity was vitally important for most defined benefit schemes closed to new members and in net decumulation, Austin said. This was becoming more and more challenging with many schemes across Europe finding it very hard to balance liquidity while creating returns, he added.
Northern Trust’s white paper – titled “Cash: an Asset in Adolescence” – detailed several reasons for asset owners’ difficulties.
Firstly investors, such as pension funds, have increased their allocation to cash because they need to support their evolving investment strategies, but in the current low interest rate environment they can expect a zero rate of return, which can become negative after inflation.
Secondly, the firm said, regulations such as the European Markets Infrastructure Regulation – which requires over-the-counter derivatives to be cleared through a central clearing counterparty — have unintentionally posed liquidity challenges.
”Cash is an important investment-enabler — pension funds cannot earn from it but cannot invest without it,” Austin said.
However, pension funds could no longer be passive about cash as the available liquidity in the market tightened and returns on cash positions were reduced, he said.
Northern Trust said that in order to start to tackle what it termed the “liquidity conundrum”, pension funds should understand investment portfolios from a liquidity perspective by maintaining a “liquidity ladder” and considering future calls on cash.
They should also model and stress test their asset-liquidity profiles to be aware of the worst-case scenario and potential sources of liquidity in normal and stressed markets.
As well as this, pension funds should determine optimal short and long cash positions and arrangements.
Penelope Biggs, head of the Institutional Investor Group for Europe, the Middle East and Africa at Northern Trust, said: “We believe that understanding a portfolio from the point of view of how liquid it might be at any point in time is critical, particularly as the cost of cash liquidity will only continue to increase.”