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How Much Capacity Does Your Plan Have for Illiquid Assets?

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  • On: 11/02/2023 17:51:10
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By: Eric Friedman and John Sullivan, Aon

This article summarizes research on how characteristics of different public pension plans affect their capacity to invest in illiquid assets. Of the characteristics analyzed, a plan's funding policy had the largest impact on its ability to invest in illiquid assets.
How Much Capacity Does Your Plan Have for Illiquid Assets?

This is an excerpt from NCPERS Fall 2023 issue of PERSist, originally published October 24, 2023.

Many public pension funds find value in illiquid assets such as private equity, private credit, and real assets, but they are often uncertain about how much capacity they have for illiquidity. We did research to answer that question, including understanding how different plan characteristics impact the answer. There are several factors affecting a public pension plan's ability to invest in illiquid assets: plan demographics and maturity, funded ratio, and funding policy, to name a few.  While all of these factors are important, what we found may be surprising: of all the plan characteristics we analyzed, a plan's funding policy had the largest impact on a plan's ability to invest in illiquid assets.
Specifically, the biggest driver of the capacity for illiquid assets is how the funding policy responds to periods of poor investment performance. Actuarial funding policies result in increased funding when the funded ratio decreases, thus creating a source of additional liquidity when it is most needed. That is, in a market downturn, a plan in a net cash outflow position (more benefit payments than contributions) will turn more neutral or potentially to a net inflow position as contributions increase, which makes the portfolio more resilient and able to have higher allocations to illiquid assets.
Alternatively, plans with contribution policies that are insensitive to the funded ratio (such as contributions that are defined by statute as a level percentage of payroll) are less equipped to navigate challenging market environments and indicate a lower capacity for illiquid assets. The plans most at risk of a liquidity event are those with low funded ratios, static or non-actuarial contribution policies, and high allocations to illiquid assets.
We came to this conclusion through a stress testing analysis. Liquidity risk manifests itself in stressed economic environments when the actual asset allocation deviates from the target allocation and the investor is unable to rebalance. Therefore, we analyzed how far actual allocations to illiquid assets would drift from their target allocations in stressed economic environments. We did this for several representative pension plans with varying characteristics such as funded ratio, demographic profile, liability duration, and contribution policy. While all of these characteristics had some influence on a plan's capacity for illiquid assets, it was the contribution policy that was the most influential.
We find this result to be particularly interesting because contribution policy is not considered by many public funds in assessing their capacity for illiquid assets. It is common to consider the cash flow profile (maturity) of the plan, but too often investors look at cash flow projections only in a normal economic environment, rather than a stressed one. This approach doesn't provide critical information about how the contributions will change in a stressed environment. For public funds with high allocations to illiquid assets, this is an opportunity for improvement.
Our experience from doing this type of analysis is that most public pension plans can tolerate a higher level of illiquid assets from a liquidity management perspective. It is also worth noting that some plans have contribution “policies,” but those policies may not always be followed, especially in times of stress when the actuarial contributions increase. Fiduciaries should be realistic about the likelihood that contributions will be made in stressed economic environments, and study scenarios accordingly.
About the authors:

Eric Friedman is a Partner with Aon's Investment Policy Services team in the U.S. In his role as the U.S. Director of Content Development, he leads the firm's U.S. efforts in developing intellectual capital to improve its investment advice to institutional investors. Eric holds the designations of Fellow of the Society of Actuaries, Enrolled Actuary, and Chartered Financial Analyst.

John Sullivan is an Associate Partner with Aon's Investment Policy Services team in the U.S. John's specialty is Asset-Liability Management for corporate and public sector defined benefit and post-retirement welfare plans with a particular emphasis on the public sector.

Disclosure: The opinions referenced are as of the date of publication and are subject to change. The information contained herein is for informational purposes only and should not be considered investment advice. This content summarizes a longer paper that can be provided upon request.


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