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The Actuary The magazine of the Institute & Faculty of Actuaries
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Investment: Exploiting liquidity requirements

Pension schemes have long used econometric (non-risk neutral) valuation methods. The argument is often that they are able to invest for the long term, with their need for liquidity comparatively well known. The risk that they unexpectedly need to pay out all of their liabilities in the next few years is very small.

While the debate around the merits of these valuation approaches will continue, the long-term, generally non-callable nature of pension scheme liabilities means that there is less need to invest in highly liquid assets than for almost all other investors.

Pension schemes have been in an excellent position to exploit this, especially in the last couple of years. Many other investors have been forced into selling assets or have needed to alter their portfolios given various constraints (the need for liquidity and solvency constraints being good examples). This has resulted in cheap prices for certain assets. Pension schemes should not be afraid to take advantage of the fact that they don’t have the same constraints and be willing to invest a proportion of their assets in such opportunities.

Crucially, in order to be able to do that, it is essential for pension schemes to establish a governance framework that allows them to make decisions on these opportunities in a timely manner. This can be achieved by delegating some decisions to a specialist sub- set of the trustee board, or to an investment manager or professional fiduciary. The size of a particular scheme will be an important consideration in deciding how best to do this. Quite a few pension schemes in Holland have relished their roles to make additional returns as providers of liquidity, in particular since 2007.

We can look at a recent example where an opportunity was available for those able to invest in a timely manner. Just after the collapse of Lehman Brothers, investors were very keen to move into the most liquid assets possible. As a result, the yields on short-dated government bonds fell sharply. Part of this flight to more liquid assets involved the selling of long-dated inflation-linked gilts, as many did not consider them sufficiently liquid.

As a result, yields on these assets and inflation expectations changed such that they could be purchased at attractive levels both on an outright real-yield and asset-swap basis 1. The 2047 inflation-linked gilt reached LIBOR + 185 on an asset-swap basis; a return of 1.85% above cash for purchasing a long-dated UK inflation-linked government bond. That is a healthy spread. Quite a few pension schemes that were set up to do so invested.

As markets calmed down, yields fell such that near the end of 2009 they were at around LIBOR + 40 (resulting in a return on a fully funded investment of around 30%). As a result, some of those that had invested sold and reaped a significant profit, while others decided to keep their investment. The governance structures of many pension schemes made it very difficult to invest in that idea. However, an increasing appreciation of these issues is prompting many to reconsider their approach.

At the time of writing, sovereign default is a big topic and there are interesting opportunities around the relative levels of government and corporate bond returns. Given the comparative certainty over pension scheme liabilities, not being in a position to take advantage — whatever the approach used to do that might be — is a missed opportunity.

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1 Asset swaps involve purchasing the asset and exchanging the returns on that asset for cash (LIBOR) returns plus a specified spread. This is a commonly used approach by investors who want a particular asset exposure (in this case UK government credit risk and the liquidity risk) but without the associated duration risks. It is also a helpful way of comparing returns on investments by stripping out the shape of the yield curve.

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Chris Watts works in Morgan Stanley’s Fixed Income Group helping to provide multi-asset solutions for UK pension schemes