Illiquidity premiums move up agenda, but questions over cash flow remain

Experts in the industry agree that pension funds should increase their illiquidity exposure, but are divided over whether an index, such as Willis Towers Watson’s Illiquidity Risk Premium Index, is the best way forward.

Metrics are helpful, but there is too great a focus on them without enough qualitative understanding

Tim Giles, Aon Hewitt

Chris Redmond, global head of credit research at the consultancy, said of the index: “We have a mantra: what gets measured gets managed."

He said the consultancy has long been advising clients to acquire more illiquidity. "The index just gives more robust quantitative support for this advice.”

Redmond said it is useful because it shows investors how close they are to the maximum level of illiquidity they can tolerate. 

“UK pension schemes have more tolerance for illiquidity than they believe, and they should be taking a more holistic approach” to their portfolios, he said. “There are many real estate lending opportunities, as well as infrastructure debt.”

An earlier report by the consultancy mentioned the high likelihood of an imminent “downside event” that would push up illiquidity premia, although Redmond said that “this event is less dramatic and more of a cyclical recession”.

Cash flow trumps illiquidity

However, Tim Giles, partner at consultancy Aon Hewitt, emphasised that schemes should make sure that their assets are meeting their benefit payments. “In a way illiquidity is almost irrelevant – whatever generates cash flow” is what should matter, he said.

Giles added that greater standardisation of the credit market would be a mixed blessing. “The premium is created by illiquid assets’ heterogeneity, so standardising the market can damage this advantage,” he said.

He was cautious regarding Willis Towers Watson's index. “Metrics are helpful, but there is too great a focus on them without enough qualitative understanding,” Giles said.

Giles said that to take advantage of the premium at minimum risk, schemes should “match the illiquidity of assets and liabilities”.

He said the two considerations for pension schemes increasing their illiquid exposure should be “default risk and cash flows expected from an investment”.

Schemes underestimate market illiquidity

Simon Cohen, head of investment at Dalriada Trustees, suggested that “pension schemes maybe don’t appreciate just how illiquid the credit market has become”.

Cohen also said that most pension schemes fail to negotiate fair levels of illiquidity risk premia for themselves, explaining that they “might not be getting fair terms because they are not conscious of the [liquidity] issue”. He added, however, that the Willis Towers Watson reports might help put the topic on the agenda.

For schemes maximising their illiquidity, Cohen recommended looking at infrastructure and private equity.

He added that schemes should “speak to their consultants, and carefully select the right investments” for them to take advantage of illiquidity at minimum risk.

Use many premia to diversify portfolios

David Curtis, head of UK institutional business at Goldman Sachs Asset Management, said: “If there is a reward for tying up your capital, then it is prudent to build that reward into your portfolio… it is a discrete, consistent source of return.”

He added that the attractiveness of illiquidity “is not a new phenomenon, but there is now more acceptance that it is a good diversifier”.

He said many clients were seeking greater exposure to illiquidity. "So with or without an index, they should be incorporating more into their portfolios.”

He pointed out several asset classes particularly well-suited for increasing illiquidity exposure. “Private debt [is good], as it complements the public debt already in investors’ portfolios”, Curtis said, as well as bank loans and collateralised loan obligations.

Schemes should ask themselves three things, Curtis said: “Do you believe in the premia; how much do you want in your portfolio; and how will you implement the incorporation of the premia you want?”

He emphasised that most schemes will need assistance from fiduciary managers with the third point.  

Overall, Curtis emphasised the importance of diversity: “Use many premia to build a diversified portfolio.”