TPR: Trustees must ‘improve their understanding’ of liquidity risks

In a blog post on Friday, TPR’s executive director of regulatory policy, analysis and advice, David Fairs, alerted to the importance of trustees getting to grips with the specific cash flow and liquidity dynamics of their schemes, and how those “might develop in the future and how they might change in times of market stress”.

“We also want trustees to better understand the impact that margin calls might have on those dynamics and how mark-to-market/mark-to-model impacts might reflect on the values of assets realisable in times of market stress,” he wrote.

Defined contribution schemes and open or immature DC schemes might be able to take longer-term approaches to their investments, which may include an appetite for illiquid investments, he said.

Closed and “very mature” defined benefit schemes, on the other hand, may need to adopt shorter-term investment horizons in order to prioritise benefit outgoings, or to facilitate a transfer to an insurer.

“They may need to focus more on maintaining ongoing sources of liquidity and may have a limited appetite for illiquid investments,” Fairs said.

The aftermath of the 2008 global financial crisis presented new opportunities to invest in debt “as credit risk became increasingly intermediated outside the banking sector”. But he noted that “the search for yield” led some investors “further down the yield curve and also into some categories of alternative investments”. 

“This has made them more vulnerable to sudden shifts in market sentiment, financial conditions tightening and market liquidity,” he wrote. 

“Against that background, we have become more interested in understanding how trustees manage their scheme liquidity risks and to ensure that trustees actively monitor and manage their scheme liquidity requirements.”

TPR’s increased interest in this area has been reflected in several areas of its work, not least its Covid-19 guidance, which “emphasised the need for trustees to consider their liquidity needs and how they might develop”, and its interim superfunds regime, which included a requirement for a liquidity risk management plan to be prepared.

Although governments and central banks worldwide have intervened in a bid to stabilise markets in response to the Covid-19 pandemic crisis, Fairs warned that future interventions could not be guaranteed.

TPR and other regulators are working with the Bank of England’s Financial Policy Committee to “improve financial resiliency within the market system”, and part of this will involve encouraging pension scheme trustees to “improve their understanding of the liquidity risks their schemes are exposed to and to actively monitor and mitigate those risks”, he continued.

TPR expects “more robust liquidity risk analysis” to be carried out to allow, for example, for severe stress-testing for “simultaneous market shifts”, the extent and composition of derivatives’ exposure to margin calls, and “alternative assumptions that might apply in times of severe market stress and the impact they might have on the ability of assets to be liquidated and their realisable values”.

Fairs wrote: “Some investments that are not ‘admitted to trading on regulated markets’ may form a useful part of a scheme’s investments, and some illiquid investments may offer the opportunity for enhanced returns, better risk diversification and improved scheme outcomes.

“However, we believe that trustees need to better understand how risks can develop within their schemes, particularly in times of market stress.”