Why Managing Liquidity is Important for Pension Funds?
Pension funds have traditionally been viewed as long-term investors. They are an investment vehicle in which individuals invest over the course of their working lives and remove money only after the age of retirement. Hence, liquidity was not considered to be a very big problem for the pension fund industry until recently. However, in the recent past, many drastic changes have taken place in the pension fund industry. As a result, liquidity has become a challenge for the pension fund industry.
In this article, we will have a closer look at why liquidity management has become a challenge for the pension fund industry and what can be done to better manage liquidity in this industry.
Why Liquidity Has Become a Problem?
The nature of the pension funds business and their investments has changed drastically over the past few years. This has happened because of some key changes that have taken place in the macro-environment. The two most important ones are as follows:
- Lower Interest Rates: The interest rates have been at their lowest in the past decade. Ever since the 2008 global recession broke out, banks have been keeping the interest rates low in order to stimulate the economy. As a result, the returns earned by the pension funds have also fallen very low. Pension funds can no longer afford to not take risks. There is increased competition amongst pension funds to generate more returns.
The end result is that they have started investing a higher proportion of their money in risky and illiquid assets. It is not uncommon for pension funds to have their money invested in alternative assets such as mortgage-backed securities, emerging markets equities, etc. This means that now pension funds can be exposed to significant liquidity risks in the event of a turmoil in financial markets. The lower for longer interest rates policy has exposed pension funds to significant financial risk by making it imperative for them to invest in riskier assets.
- Ageing Population: The population demographics have changed significantly in larger markets such as the United States and Europe. These economies have consistently witnessed a fall in their birth rates. As a result, the number of people entering the workforce is lower than the number of people exiting the workforce. The end result is that the money going into pension funds is lower than the money coming out of pension funds in many countries. This negative cash flow situation has created panic in the pension funds industry.
Liquidity Lessons From 2008
The recession which happened in 2008 was a turning point for the pension funds industry. This is because the world was exposed to the perils of liquidity risk in the new world order. The 2008 crisis saw a credit freeze take effect. This meant that it was almost impossible for any financial institution to sell their assets and generate cash to pay off their creditors. There were several asset classes that were impacted by this credit freeze. Interbank markets that are considered to be very safe were also witnessing an absence of investors.
Now, since pension funds are invested in many risky assets, there is a chance that they may be exposed to a similar situation in the near future. This can be detrimental to the entire economy since if a pension fund defaults, a large number of people will become reliant on welfare payments. It is for this reason that governments all over the world have started taking note and have also created regulations to ensure that pension fund managers are not reckless when it comes to managing pension fund finances.
How does Liquidity need to be Managed?
Since liquidity management has become a buzzword in the pension fund universe, many funds have become proactive in setting up policies that enable them to convince investors and governments that they are managing their liquidity effectively. This is usually done with a three-part strategy.
- Accurate Forecasts: Pension funds have always been making an attempt to predict their cash flows. However, they have not been able to do so very accurately. This is because their cash flows are dependent upon several factors such as the unemployment rate, interest rates, life expectancy, and also on the number of people retiring.
Pension funds have started investing heavily in technology since it enables them to make a more accurate prediction of their cash flow needs. Pension funds have now started using artificial intelligence and machine learning technologies to be able to make better cash flow predictions since it gives them a competitive edge.
- Short Term Investments: Once pension funds have been able to decipher exactly how much their short-term liabilities are likely to be, they need to make short-term investments that will remain liquid.
Pension funds need to ascertain the value of their portfolio under various market circumstances. For instance, they must be aware of the amount of cash flow that they will be able to recoup from their short-term investments if the market stays down for a long period of time.
- Having a Healthy Buffer: Pension funds must be aware of the fact that even though their cash flow planning seems immaculate, it could still lead to big problems if they do not have a healthy buffer. It is now common practice for many firms to have a cash healthy buffer on hand to help them meet any unforeseen circumstances which their business might end up facing.
The bottom line is that liquidity management has become a central area in the field of pension fund management because of the various changes which have taken place in the macroeconomic environment.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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