Implementation: A liquid diet for trustees
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Liquidity in a pension fund context can mean a number of things. As long-term investors, pension funds can harvest the illiquidity premia by investing in private markets, which they have been doing increasingly over the past 10 years.1 On the other hand, pension funds are required to meet their liabilities and so need enough liquidity to ensure payment of benefits to members. For pension funds, these are the two most distinct expressions of the term ‘liquidity’. The balancing act of locking assets up whilst retaining enough liquidity to meet member benefits, if done correctly, can improve the returns generated from a scheme’s asset allocation.
In the UK, the majority of pension funds have become cash flow negative. This change in cash flow profile has been brought on as pension funds have increasingly closed their schemes to new entrants and future accruals. Due to the increasing maturity of their cash flow profile, they are now paying out more to their members in the form of member benefits than they receive from the combination of company contributions and investment return on assets.
Mercer, in its European Asset Allocation survey reported that 55% of UK DB PFs are now cash flow negative.2 This is not a trend that will reverse, Mercer adds that it expects this number to rise to 85% over the next decade. The UK pension industry needs to pay out liabilities of over £1.7trn (€1.9trn) over the next 20 years or so.3
The profile of these cash flows is not linear either. As baby-boomers retire, the bulge bracket of pension fund liabilities will mean the amount in sterling that needs to be paid out on a monthly basis for the average fund may dramatically increase from its current position.
Those schemes that effectively plan how to navigate this liquidity challenge will be better placed to achieve their long-term funding objectives than those that do not.
Currently, cash flow negative schemes may be adopting a series of measures. Some schemes are moving to cash flow-driven investing (CDI), which seeks to construct a portfolio of income assets, bonds and other contractual cash flow generating assets, which are projected to meet all the liability cash flows as they become due.
CDI can be a highly effective framework for pension schemes to use as a way of mapping their assets versus their liabilities in a way that focuses on cash flow, particularly for more mature schemes. In the US, some of the most mature schemes are adopting liquid beta sleeves, alongside a CDI-type framework.
Liquid beta sleeves are a combination of index products that seek to provide market exposure in a way that is liquid and customisable to fit a scheme’s specific needs. Pension funds with maturing liability profiles are looking to liquidity sleeves to form part of the solution to help navigate the cash flow negative journey.
In this context, liquid beta sleeves form a small percentage of a pensions fund’s total asset allocation, perhaps 5–10%, and could be used to deal with the cash flow requirements of the scheme alongside traditional money market funds. Typically, these liquidity sleeves reflect, as far as possible, the strategic asset allocation of the pension fund itself. To this end, the liquidity sleeve also helps the fund avoid a large build-up of cash that can arise as member benefits become more burdensome. We estimate that in aggregate current cash levels across UK pension funds are now in excess of $50bn (€42.8bn) and part of that capital will be earmarked to meet member benefits.4
A US pension fund with a mature liability profile was building up excess cash as a buffer to help meet its increasing cash flow burden as it became more cash flow negative. The client was also finding it challenging to liquidate assets monthly.
A combination of exchange-traded funds (ETFs) was used to replicate the strategic asset allocation of the pension fund. Their asset allocation was a typical mix of public and private markets, across a variety of asset classes. Following analysis, we constructed a liquidity sleeve with a correlation of 0.99 over a one, three and five-year period. The sleeve itself was a composition of five underlying iShares ETFs with a weighted average total expense ratio (TER) of 12bps.5
Ultimately, the client outsourced the implementation of the liquidity sleeve to BlackRock to also offload the governance burden of managing the associated cash flows. The liquidity sleeve periodically rebalances back to the pension fund’s strategic asset allocation to ensure that its correlation remains high over time.
Increasing opportunity set across index investing
The topic of liquidity sleeves is becoming relevant because of the maturity of UK pension fund liabilities. The evolution in choices across indexing products is helping to improve the replicability of liquidity sleeves themselves. We believe that indexing has evolved from two perspectives.
• Exposures. Whilst market capitalisation weighted indices still dominate index investing across UK pension funds, the breadth of options has widened. Investors are now able to access single countries, common factors and specific sectors through ETFs. The number of exchange-traded products in Europe has grown from roughly 500 in 2007 to a figure close to 2,400 today.6
• Wrappers. Pension funds have a variety of implementation options available to them when it comes to indexing. Index mutual funds remain the mainstay for most pension funds. However, price dynamics around derivatives and ETFs have changed. The implicit cost of holding certain index derivatives has increased as a function of changes in regulation, post the global financial crisis. Meanwhile, the holding costs associated with ETFs are downward trending, making them much more comparable to traditional index mutual funds. As the ETF market has grown, transaction costs have shrunk as a function of increased trading on the secondary market. Lower transaction costs make ETFs a good fit to play a role in liquid beta sleeves given that cash flows will require funds to be bought and sold regularly.
As DB schemes continue to navigate towards the end game, managing the draw down of their assets to meet their maturing liability profiles will be a difficult task. The sophistication of the indexing landscape has just so happened to coincide with this stage of the DB journey. The coming together of these two different aspects of our industry serves to provide maturing pension funds with a new way of solving for cash flow negativity.
1, 2 Source: Mercer, as of 19 June 2018.
3 Source: The Purple Book, Pension Protection Fund, as of 5 December 2017.
4 Source: Willis Towers Watson, as of 28 February 2018.
5 Source: BlackRock, as of 31 August 2018.
6 Source: BlackRock, as of 30 June 2018.
Armit Bhambra, head of iShares retirement at BlackRock