Investor Thinking - Mind the Gap
Historically many pension funds have sold assets when rebalancing out of an outperforming asset class or to de-risk after achieving a target funding level or as part of a strategic asset allocation change. Each of these reasons has involved some element of choice or flexibility. Now, with the closure of pension schemes (to new entrants and future accrual) the tipping point that requires a more systematic focus on cash-flow requirements has come earlier than expected. The need to pay benefits (in excess of the contribution and existing income generation) is often forcing asset sales to fund cash flows. This adds another dimension for trustees and their advisors to think about. In this paper we outline the risk of such forced selling.
The risks with becoming a forced seller
Pension scheme assets are ultimately there to be sold to meet pension scheme benefits. However it is important for schemes that are still working towards deficit recovery to be as efficient as possible in using their limited resources. This includes, as far as possible, avoiding forced selling of assets. This is not always possible but if asset sales without any constraints is the only strategy on which that a pension scheme relies from day one to pay benefits (net of contributions and income) from the existing portfolio, that automatically makes such a pension scheme a forced seller with the following implications:
Selling assets constantly over a prolonged down market
A forced seller could get lucky, and catch a rising tide in the market to fund an oncoming string of pension payments. This would have a good outcome. However, relying on luck is not a prudent investment strategy. So if regular asset sales end up being made particularly in down markets (assuming this is the equity market and equities/growth assets are being used to fund benefit payments net of contributions), a scheme could burn through a lot of its assets very quickly. This could negate the deficit recovery work done so far and damage further recovery due to a loss in expected return at the total portfolio level combined with path dependency leading to less time and assets to recover from the mean reversion of such a market.
Selling regularly could work in favour of pension schemes in consistently rising markets or work against pension schemes in falling markets. Either way, a plan to use asset sales regularly to pay pensions relinquishes control of asset sales (by making it an inflexible exercise) and does not help to mitigate the downside risk of selling in a declining market.
Having a well-diversified portfolio is one argument in favour of using regular asset sales, but a well-diversified portfolio does not mean that there will always be an outperforming asset class to sell at the time required. Growth assets can become highly correlated in times of stress giving the forced seller no option but to crystallise a loss to fair value – which could hurt the direction of travel of the scheme. Stressed market conditions, could also lead to a momentarily skewed asset allocation of a well-diversified portfolio (versus the long-term strategic asset allocation). This could complicate decision making, for example, selling bonds instead of equities that are temporarily underweight.
Risk of higher transaction costs of selling:
Selling always has an associated transaction cost. However, if a scheme is forced to sell assets regardless of market conditions, transaction costs of sales can be higher than expected over a long period of time. In addition, if it so happens that a sale is required soon after a negative shock to the markets, not only will the scheme get hit on the valuation received at sale (discussed earlier) but also, the transaction cost of sale (bid-ask spread) will be highest in a distressed market.
Managing the risk of ending up as a forced seller
To protect from risks described above and for ease of governance (trustee availability for quorum/the most recent asset valuations/ indeed to have some sales flexibility) schemes tend to keep a cash buffer. A small cash buffer is perhaps reasonable, but excessive cash buffers rely on a view taken in advance that markets will fall, causing a drag on returns in normal market conditions – thereby impacting the recovery plan. Ideally a cash buffer would be kept to the very minimum, to ensure assets are being used towards deficit recovery. In addition, a cash buffer might be helpful in falling markets but not in markets that stay low over a very long period as topping up the cash buffer will become a problem.
Structuring a portfolio to generate more income is another step towards managing the risk of being a forced seller. Using long lease assets or income generating equity or even synthetic equities (to free up cash1) will help with this.
Another way to generate income would be to use corporate bonds. It is important to note that corporate bonds are an asset class that are income generating and in fact, do not need be ‘sold’ to be realised. Using corporate bonds, structured in a manner that allows for income generation and maturity to be used, can help save transaction costs and avoid schemes being subject to market conditions at the point of sale.
By definition, it is difficult to plan for the unexpected and to determine a scheme’s exact cash flow requirements in advance. However there is more (than keeping a cash buffer) that can be done to address the gap between the income that is available from existing assets, the contribution income (if any) and the required benefit out flow.
One way to avoid being a forced seller to fund that gap is to use coupon and maturity proceeds from a corporate bond portfolio. Insurance companies structure assets in this way and, in the long term, corporate bonds (alongside hedging assets) will form the bulk of pension scheme assets as well. This makes the use of coupon generating corporate bonds and maturity proceeds a good solution to consider in both the short and longer term. A reservoir of coupon generating bonds, besides having the potential of a decent return could:
- provide more flexibility in timing and choice of the asset selling decision (required to rebalance the portfolio or top up this reservoir) giving stressed assets time to mean revert if need be
- help avoid incurring regular transaction costs and reduce the potential for these to be excessive in times of stress
- be structured to serve a pre-defined number of years of pension payments
Relying primarily on asset sales – to plug the gap means losing control on the flexibility of deciding when and what assets to sell, opening up a scheme to the risk of selling in a long down market and hampering wider pension plan objectives of liability hedging and deficit recovery. It is a risk that can be managed and one that is not compensated by any premium, so not worth taking.
1 The act of moving from physical equity to synthetic equity actually will remove any potential income as physical equity will pay dividends but with synthetic equity the dividends will make up part of the index which is used as part of the contract for difference. However by implementing synthetic equity a scheme is able to free up capital which can used as either cash to pay benefits or as gilts/credit which can pay benefits/provide cash flows – the synthetic equity element therefore provides more flexibility of how and when you reduce equity exposure by controlling the size of the contracts.
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