Pension funds must take ‘extreme care’ with liquidity risks, OECD warns
- December 31, 2022
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Pension funds should be “extremely careful” when investing in illiquid assets, as rising interest rates and falling stock markets increase the likelihood of their having to access cash quickly, the OECD has warned.
In the recent era of low interest rates, pension funds poured money into alternative investments, such as infrastructure projects and private equity, in an effort to escape the low yields available on government bonds.
But such investments are typically illiquid, meaning the funds cannot quickly convert them into cash if needed. While there has been little need for funds to do that over the past decade, the UK pension crisis in October exposed how a sharp rise in interest rates can change that.
“There is a call now for greater flexibility in regulation to allow [defined contribution] schemes to invest in illiquids and infrastructure and this is fine,” said Pablo Antolin, principal economist at the private pension unit of the OECD Financial Affairs Division. “But we also have to be extremely careful because liquidity issues are very important in the management of investment strategies.”
Alongside the liquidity risks, the OECD cautioned that the level of due diligence required on alternative investments is likely to be beyond the reach of many smaller funds.
“When you have a big pension fund, with a large investment team, which is more highly qualified, they can afford to make those choices and assess those illiquids quite well to introduce them,” said Antolin. “But small and medium-sized pension funds can’t and they need the financial instruments to invest . . . What we have seen is there are not many financial instruments out there to invest in illiquids and infrastructure.”
The warning comes as pension funds’ appetite for alternative investments show little sign of slowing. In December, BlackRock, the world’s largest asset manager, said the role of private assets, which span everything from infrastructure to private credit, is becoming “more important than ever” as more companies turn to them for returns.
Allocations to alternative assets have brought benefits to global public pension plans.
For example, the Virginia Retirement System, which has 778,000 members, reported its holdings of public stocks and fixed income were down 14.8 per cent and 10.6 per cent respectively for its 2022 fiscal year. In contrast, its real assets and private equity returned 21.7 per cent and 27.4 per cent over the same period.
Almost half of public pension funds globally with more than $3tn in assets plan to increase their exposure to alternatives, according to a recent survey by the Official Monetary and Financial Institutions Forum (OMFIF).
Assets that provide a hedge against inflation, including infrastructure and some real estate, were among those most favoured, the survey found.
“Given this stark outperformance and lingering concerns among [global pension funds] about inflation, it’s no surprise that there is appetite to move further into real assets and private equity,” OMFIF said at an independent forum for central banking, economic policy and public investment.
However, OMFIF pointed out the risks in this approach.
“Chasing higher returns in relatively illiquid markets gives funds less flexibility to change their strategies in future,” the report said, adding that “the recent UK pension crisis suggests it is necessary to hold liquid assets as a way to instantly raise cash in bad times”.