How can I use the liquidity of my pension fund to improve returns?
Effective liquidity management reduces risks and inefficiencies
Liquidity management is becoming increasingly important for pension funds. The best way to improve liquidity management is to set up a treasury function within the matching portfolio.
By Rik Klerkx, head of LDI at Cardano
Increasing number of short-term liquidity requirements
Pension funds are long-term investors, but they are facing more and more short-term liquidity requirements, which can give rise to liquidity risks or lower returns at the same level of risk because liquidity premiums can no longer be collected. Liquidity management is becoming increasingly important for more mature pension funds, which have a negative net cash flow because pension benefits are substantially higher than pension contributions.
However, a healthy cash flow forecast is also desirable for young and growing funds in order to invest premium income efficiently. On top of that, cash is becoming increasingly important for collateral management, now bonds are not accepted as easily as in the past.
Effective liquidity management can be optimised by setting up a treasury function in the matching portfolio, as this portfolio serves as the basis for the interest rate hedge and has the greatest need for liquidity due to collateral management. As a result, the person charged with managing this fund has better, faster insight into the liquidity risks run by the pension fund.
Optimal treasury function consists of three parts
There are three elements to optimising the treasury function. First and foremost, you need insight into cash flows based on a forecast of certain and uncertain cash flows, which the treasure can use to anticipate surpluses or deficits and prevent unnecessarily high and expensive liquidity buffers.
The second component of the treasury function consists of investing surplus liquidity with a short horizon, guaranteeing its availability in the very short term. Not only will this translate into 20-40bps return, but it will also improve the fund’s risk profile. Finally, the treasure function should have one more instruments at its disposal to attract liquidity in the event of a short-term deficit, such as including cash in the strategic investment mix, replacing investments with derivatives and temporarily substituting investments for cash. Which of these is best will differ from one pension fund to another, but they may have a major impact on the costs and revenues of the treasury as a whole.
Setting up the treasury requires policy-based foundations, and as liquidity management is becoming increasingly important, this will impact strategic asset allocation. As such, it’s advisable to set a liquidity buffer to prevent sudden liquidity deficits or surplus and to create more opportunities to attract liquidity. It may even be desirable to specify explicitly how much each asset class is to contribute to liquidity management.