Pension Fund’s Illiquid Assets Allocation Under Liquidity and Capital Constraints
In the current low-interest environment, the popularity of illiquid investments among institutional investors keeps increasing. Particularly from the perspective of defined benefits pension funds, the opportunity to harvest liquidity premiums promises to remediate the pressure of delivering contracted payments. However, the degree to which pension funds allocate resources to illiquid assets varies substantially. Using data from Dutch pension funds, Broeders, Jansen, and Werker (2017) empirically study the impact of liquidity and capital constraints on the allocation of pension funds to illiquid assets and find that both factors significantly interact.
1. With regard to liability duration, considering capital and liquidity constraints simultaneously proves important. While a longer duration of liabilities comes with reduced liquidity constraints due to less short-term pension obligations, longer durations also incur increases in capital constraints due to the increased exposure to interest rate risk. In line with this dynamic, the study shows that the allocation to illiquid assets grows with liability duration (0.64% per year) and then falls again (0.75% per year) once 17.5 years are reached.
2. A similar dynamic holds for relation of interest rate hedging and illiquid assets. Reducing balance sheet interest rate exposure with interest rate swaps creates room for illiquid investments through reductions in capital constraints. However, interest rate hedging also generates short-term liquidity constraints, since it raises collateral requirements. In sum, no significant relation between interest rate hedging and illiquid asset allocation can be documented – both factors might cancel out.
3. In contrast, currency hedging is positively related to illiquid investments. A stronger currency risk management leaves more capacity for a lock-in of capital in illiquid assets.
The outlined results indicate that capital constraints required for exposure to interest rate risk attenuate pension funds’ investments in illiquid assets. However, the authors stress that the evidence should not be interpreted as a call for reduced requirements: interest rate risk is inevitable in long term guarantees. In order to give pension funds more investment freedom, a change in the nature of the long term liabilities could be considered. This however implies a shift of interest rate risk from the pension fund to the beneficiary. The beneficiary should then be able to understand and accept the interest rate risk.